INDIA’S ECONOMIC REFORMS: AN APPRAISAL

Montek S. Ahluwalia

India’s economic reforms began in 1991 when a newly elected Congress government, facing an
exceptionally severe balance of payments crisis, embarked on a programme of short term stabilisation
combined with a longer term programme of comprehensive structural reforms. Rethinking on economic
policy had begun earlier in the mid-eighties by when the limitations of a development strategy based on
import substitution, public sector dominance and pervasive government control over the private sector
had become evident, but the policy response at the time was limited to liberalising particular aspects of
the control system without changing the system itself in any fundamental way. The reforms initiated in
1991 were different precisely because they recognised the need for a system change, involving
liberalisation of government controls, a larger role for the private sector and greater integration with the
world economy.

The broad outline of the reforms was not very different from the reforms undertaken by many developing
countries in the 1980s. Where India’s reforms differed was the much more gradualist pace at which they
were implemented. 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 changes
could be implemented and this meant that the pace of reforms was often frustratingly slow. Daniel Yergin
(1997) captures the mood of frustration when he wonders whether the Hindu rate of growth has been
replaced by the Hindu rate of change! Yet even a gradualist process can achieve significant results over
time and India’s reforms have been underway now for seven years. . That a consensus of sorts has
evolved is perhaps reflected in the fact that the reforms initiated by the Congress Government in 1991
were continued by the United Front coalition which came to power in 1996 and have also been broadly
endorsed by the BJP led government which took office in 1998. This is not to say that economic policy
issues are no longer controversial and there is complete consensus on all points. Differences do exist,
especially in emphases and nuance but these are often as much evident within parties as across the
political spectrum.

3. This paper attempts to evaluate what has been achieved by gradualism in this seven year period which
has seen three different governments in office - the Congress government which initiated the reforms in
1991, the United Front coalition which continued the process in 1996 and 1997 and finally the BJP led
coalition which took office in March 1998 and has also declared its intention of strengthening the reforms.
The paper distinguishes between achievements in terms of the end results in terms of the actual
performance of the economy in this period and achievements achievements in terms of policy reforms
actually implemented. implemented. The distinction is important because dramatic policy changes in
many countries have may not always lead to actual comparable improvements in actual performance, as
has happened in many countries. Part 1 presents a summary assessment of of the paper documents
achievements in terms of the performance of the economy in the post-reform period. Parts 2 and 3
attempt to evaluate the extent to which the reforms were successful in bringing about policy changes.
Part 2 focusses on the achievement in reducing the fiscal deficit, which was a key macro-economic policy
objective and Part 3 reviews achievements in bringing about various types of structural reforms. the
cumulative change brought about over seven years in each important policy area and identifies the
unfinished task in each case. Part 3 4 presents a summary assessment assessment of achievements
thus far and of the challenges that lie ahead.

1. Economic Performance under the Reforms

To evaluate the impact of the reforms on the performance of the economy it is useful to distinguish
between two periods. The first period is the three years 1991-92 to 1993-94 which were years of crisis
management, when the primary objective of policy was to stabilise the economy. The next four years
1994-95 to 1997-98 constitute the post-stabilisation period, when the focus of policy was on the longer
term objective of putting the economy on a higher growth path. Since objectives in the two periods were
different, performance in each period must be evaluated in terms of objectives of the period. The major
parameters of macro-economic performance the two periods are summarised in Table 1.

a] Crisis Management : 1991-92 to 1993-94

India’s performance in stabilising the economy was commendable by any standards. The extent of the
achievement can be appreciated only if we recall the severity of the crisis. The surge in oil prices
triggered by the Gulf War in 1990 imposed a severe strain on a balance of payments already made fragile
by several years of large fiscal deficits and increasing external debt. Coming at a time of internal political
instability, the balance of payments problem quickly ballooned into a crisis of confidence which intensified
in 1991 even though oil prices quickly returned to normal levels. There was a flight of capital in the form of
withdrawal of non-resident deposits from the banking system and an unwillingness of international banks
to extend new loans. Foreign exchange reserves dropped to $1.2 billion in June 1991, barely sufficient for
two weeks of imports and a default on external payments appeared imminent. The shortage of foreign
exchange forced tightening of import restrictions which in turn led to a fall in industrial output. In
November 1991, the gGovernment entered into a stand-by arrangement under which the IMF would
provide $ __2.3 billion over a two year period and there was a definite expectation on both sides that the
stand-by arrangement may need to be followed by recourse to the ESAF facility because adjustment was
expected to take longer than two years.

Performance in the next two years, measured in terms of the usual parameters of growth and stability
clearly exceeded expectations (Table 1). The current account deficit, which had expanded to 3.2% of
GDP in 1990-91, was brought down to a comfortable level of 0.4% in 1993-94. Foreign exchange
reserves were rebuilt to a respectable level of 8.6 months of imports by the end of 1993-94. Inflation,
which had reached 13.7% in 1991-92, declined to 8.4% in 1993-94. Contrary to the original expectations,
there was no need to negotiate further access to IMF resources at the end of the stand-by arrangement in
November 1993. Most important of all, and in sharp contrast to stabilisation programmes in many other
countries, there was minimal disruption of growth. The rate of growth of GDP had collapsed to 0.8% in
1991-92 but it rebounded to a near normal 5.3% in 1992-93, and then accelerated to 6.2% in 1993-94.

A common concern about macro-economic stabilisation programmes is that they may hurt the poorer
sections of the population because of temporary reductions in employment resulting from demand
restraining policies, or even permanent loss of employment in certain areas because of structural change.
This aspect of performance in the stabilisation period has been examined in detail by Tendulkar (1997).
Tendulkar’s estimates (Table 2) indicate that the incidence of both rural and urban poverty declined more
or less steadily through the 1980s but this trend was briefly reversed in the early years of the reforms.
Restricting the analysis to estimates of poverty based on consumption data for a full twelve month period,
we can compare 1990-91 (July-June) with 1992 (January-December) and this comparison shows an
increase in poverty in both urban and rural areas in the first two years of the reforms. However, this
deterioration in the poverty indicators was reversed in 1993-94 (July-June). In the case of urban poverty
the reversal was complete and the incidence of poverty in 1993-94 was actually lower than in 1990-91 but
in the case of rural poverty it was marginally higher.

Tendulkar addresses the issue of whether the increase in poverty was in any sense caused by the
reforms and also the related issue of whether it could have been avoided by following a different set of
policies. He explains the increase in poverty in 1992, especially in rural areas, in terms of the decline in
foodgrain production in 1991-92 which lowered rural incomes generally and the associated increase in
food prices which lowered the real consumption levels of the poor in both urban and rural areas.
According to Tendulkar, the increase in food prices was primarily the result of the fall in foodgrain
production which had nothing to do with the reforms though it was perhaps exacerbated by the effect of
the devaluation of the rupee in 1991, which increased the import parity price, and therefore also the
domestic market price, of foodgrains.

It is difficult to determine whether the increase in poverty could have been avoided by a different mix of
policy. One can postulate a counterfactual situation where this is attempted by expanding the scale of
income generating poverty alleviation programmes, which would have raised incomes of the poor, or by
expanding the supply of subsidised foodgrains through the Public Distribution System to moderate the
rise in foodgrain prices for these years. However, both options would have required additional budgetary
expenditures which would have been difficult to finance given the severe fiscal constraints affecting the
economy at the time. Expanding supplies through the PDS would also have required additional imports of
foodgrains to supplement domestic availability and this would have required additional foreign exchange,
which was in short supply. All these considerations suggest that the measured increase in poverty in the
first two years of the reforms was largely due to exogenous factors and was probably unavoidable given
the severe constraints on policy at the time. In any case it is important to note that the deterioration was
short-lived and was almost completely reversed by 1993-94.

b] Post-Stabilisation Period 1994-95 to 1997-98

The aim of policy in the post-stabilisation period was to achieve a sustainable acceleration in growth and
here too the results were impressive. GDP grew at an average rate of 7.5% in the three years 1994-95 to
1996-97, before slowing down to 5.1% in 1997-98. The slow-down in 1997-98 is a matter for concern -
and we will return to this issue later in this paper - but it is important to note that despite the slowdown the
average growth rate in the four years 1994-95 to 1997-98 was 6.9%, significantly higher than the growth
rate of 5.6% achieved in the 1980s. Four years is not a long enough period to claim that the economy has
been firmly put on a sustainable 7% growth path, but there is little doubt that growth in the post-reform
period was faster than in the pre-reform years. It was also faster than targeted. The growth rate achieved
in the Eighth Plan period 1992-93 to 1996-97 was 6.8%, exceeding the Plan target of 6.5%.

India’s growth in the post-reform period also compares favourably with the performance of other
developing countries. As shown in Table 3, India’s post-reforms growth rate was higher than the growth of
all developing countries taken together. Comparing India with the twelve largest developing countries, we
find that China, Indonesia, Malaysia, Thailand and Chile grew faster than India in the post-reform period
while India grew faster than the other seven.

An encouraging aspect of India’s experience is the behaviour of investment in the post-reforms period.
Latin American countries undertaking economic reforms in the 1980s experienced a sharp decline in
public investment without a compensating acceleration in private investment with the result that the rate
of investment in many of these countries declined significantly and stayed depressed for a long period. In
India too, fiscal discipline did lead to a decline in public sector investment as a percentage of GDP in the
post-reform period, but this was offset by an increase in private investment in both the corporate and the
household sectors (Table 4). Total investment as a per cent of GDP therefore did not decline compared to
the pre-reform period and by 1995-96 it had actually increased to levels higher than before the reforms.
However, it is important to note that the rate of investment in the later years increased only modestly and
the average rate of investment in the post-reforms period is only marginally higher than in the pre-reform
years. The fact that GDP growth accelerated significantly after the reforms even though the investment
rate was only marginally higher suggests that productivity growth was higher - precisely the outcome one
would expect from efficiency oriented structural reforms.

Inadequate public investment in the post-reform period had an adverse impact on the economy in one
respect. It led to serious under-investment in critical infrastructure sectors such as electric power
generation, roads, railways and ports. The addition to power ggeneration capacity in the public sector
during the Eighth Plan was only a little over half the target and there were similar shortfalls in capacity
creation in roads and ports. These shortfalls would not have mattered if capacity in the private sector had
expanded, but this did not happen either. The end result was that total investment in infrastructure
development was less than it should have been, leading to large infrastructure gaps These inadequacies
did not come in the way of achieving higher economic growth in the post reform years because there was
some slack in the system, but there can be no doubt that rapid growth will be difficult to sustain in future
unless investment in infrastructure can be greatly expanded.

The high growth of the post-reform period was also accompanied by an improvement in the external
payments position. The current account deficit has varied between 1% and 1.8% of GDP and foreign
exchange reserves have been comfortable throughout. Exports grew strongly for three years after 1992-
93, averaging 20% dollar growth per year between 1993-94 and 1995-96, but then slowed down sharply
in 1996-97 and yet again in 1997-98 (Table 1). This deceleration in exports is in part a reflection of slower
growth in world trade in 1996 and 1997 measured in US dollars but even so, it is a matter of deep
concern for the future. India’s external debt indicators improved continuously in the post reforms period.
The debt service ratio had reached a worrying level of 35.3% in 1990-91 but it declined to 18.3% in 1997-
98 (Table 1). Other indicators such as the debt to GDP ratio, and the debt to exports ratio, also show
substantial improvement.

Unfortunately, it is not possible to provide reliable answers No definitive answer can be given to the all
important question of what happened to poverty in the post-stabilisation period since no poverty . The
latest available estimate of poverty is for 1993is available after 1993-94. and the next available estimate
will be for 1996-97. We know from past experience that there was no significant trend in poverty from the
mid-fifties to the late seventies when per capita income grew at very low rates but this changed after the
late 1970s as growth rates accelerated, leading to a steady though not dramatic decline in poverty.
Projecting on thise basis, of this relationship the acceleration in growth after 1993-94 must have led to a
resumption in the declining trend of poverty in the post stabilisation period but in the absence of survey
data this is at best a plausible projection. Data on social indicators such as life expectancy and infant
mortality, also provide some indication of the living standards of the poor and the information available is
summarised in Table 1. T. As shown in Table 1hese indicators show continuing improvement in the post
reform years which is consistent with the hypothesis of a continuing decline in poverty after 1993-94.
However, these positive indicators notwithstanding, it remains trueThe weight of evidence therefore
suggests that after a brief deterioration in poverty in the initial years which was quickly reversed, there
was probably a resumption of the trend of steady improvement observed in the previous decade. that
progress in reducing poverty in India is much less impressive than witnessed in East and South East Asia
in the seventies and eighties. Replication of such success would provide a much more powerful
constituency in favour of reforms then has been the case thus far. This calls for more rapid rates of
growth than have been witnessed in India thus far, sustained over a longer period and also a stronger
effort at improving social development through purposive government action.

focus The slowdown in GDP growth witnessed in 1997-98 is a worrying feature of the post-stabilisation
period. As noted above, GDP the average rate of growth in the post-reforms period remains at a
respectable level even after we include the slowdown. including the slower growth in 1997-98, but this
raises the question it is certainly relevant to ask whether 1997-98 was a purely temporary downturn or
whether it reflects the restraining impact of specific constraints which, if not tackled urgently, could force a
return to a lower growth path. This issue is examined in Part 4.

2. POLICY CHANGES UNDER THE Macro Economic Balance and the Fiscal Deficit REFORMS

18. The gradualist pace of India’s reform has at times made the reforms appear halting and even
confused at a given point in time, but even a gradualist process can bring about a significant cumulative
change over seven years. The focus of this section is to assess the cumulative change actually brought
about in some of the important areas of policy reform.

a] Reducing the Fiscal Deficit

High fiscal deficits in the 1980s were one of the root causes of the crisis of 1991 and reducing the fiscal
deficit was therefore a critical macro-economic objective a key objective not only of India’s reforms. This
was particularly important in the initial years, when the country was subject to the discipline of an IMF
programme in which fiscal deficit reduction was a key component. Ialso over the medium term as an
instrument for t was also important in the medium term as a means of reducing real rates of interest in the
economy and creating conditions in which private investment would expand rapidly.

There was encouraging progress at the start of the reforms, when the fiscal deficit was reduced from
8.3% of GDP in 1990-91 to 5.9% in 1991-92, but performance thereafter was disappointing. As shown in
Table 1, the deficit declined only marginally in 1992-93 and then increased to 7.4% in 1993-94. It declined
again thereafter, but remained well above the Finance Ministry’s medium term target. In 1993 the Ministry
had projected a fiscal deficit target of 3% by 1996-97. At one stage, it was envisaged that the fiscal deficit
would be reduced The actual fiscal deficit in 1996-97 was 5.3 per cent of GDP, more than 2 percentage
points higher than the target, and it deteriorated further to 6.1% in 1997-98. These figures refer only to the
Central Government fiscal deficit. If the deficit of the State Governments is added the combined fiscal
deficit of the Centre and States was around 7.5% in 1997-98 which is much higher than in most other
developing countries.

The inability to reduce the fiscal deficit in line with expectations is one of the most disappointing aspects
of India’s reforms. Some indication of what went wrong can be gleaned from the trends in revenues and
expenditures summarised in Table 5. The sharp reduction in the fiscal deficit in 1991-92 was achieved
through a combination of a significant decline in expenditure as a percentage of GDP and a marginal
increase in revenues. Total expenditure continued to decline as a percentage of GDP in subsequent
years but total revenues also declined. It The lack of buoyancy in revenues was the principal reason why
the fiscal deficit could not be reduced. The scope for reducing the deficit in future depends upon the
scope for reducing expenditures or increasing revenues as a percentage of GDP.

a. The scope for reducing expenditure

It is tempting to conclude that further reduction in expenditure as a percentage of GDP should be

attempted to reduce fiscal deficits in future. However, the scope for reducing expenditure should not be
overstated. As shown in Table 5, all items of expenditure except interest payments already show a steady
decline steadily as a percentage of GDP in the post-reforms period. On the face of it therefore the fiscal
problems of the economy are not due to unbridled growth of public expenditure. In fact many would argue
that India needs much larger volumes of public expenditure in health, education and other social sectors
to close the gaps which exist at present between India and other Asian countries. It is now widely
recognised that closing these gaps is essential not only as part of the strategy for poverty reduction, but
also as an essential precondition for transiting to an employment generating high growth path. Apart from
expenditure in the social sectors, there is also a need for larger expenditure in certain types of economic
infrastructure, especially in rural areas, which may not be commercially viable and can only be financed
through the Budget.

In order to expand expenditure in these areas it is necessary to reduce expenditure in other areas so that
total expenditures as a percentage of GDP are kept under control. This calls for a thorough review of
government expenditures and staffing patterns to bring about operational economies, discontinue less
important programmes and reduce inefficiently targeted subsidies. There is also a very strong case for
reducing the size of the what is clearly a bloated bureaucracy. Expenditure reduction is therefore critical
for fiscal management but more to provide room for other expenditures to expand, than to bring about a
reduction in total expenditure as a percentage of GDP. These limitations on our ability to reduce total
expenditure as a percentage of GDP underscore the role of revenue buoyancy as the principal means of
reducing fiscal deficits in future.

b. The need for buoyant tax revenues

A reduction in the As shown in Table 5, tax revenues flowing into the Central Budget actually declined as
a percentage of GDP in the first three years of the reforms. The declining trend was reversed after 1993-
94 but even so, tax revenues in 1997-98 as a percentage of GDP were about 0.5 percentage points
below the pre-reform level whereas they should have been 1.5 percentage points higher. This decline in
the tax ratio points to serious weaknesses in the tax system despite extensive reform of both direct and
indirect taxes undertaken as part of the reform programme. India’s tax reforms were based on the
Reports of Tax Reforms Committee (Chelliah Committee) appointed in 1991 and aimed at simplifying the
tax structure, moving to moderate rates of tax in line with trends in other countries, and relying upon base
broadening and improved tax administration to yield strong revenue growth. It is important to consider
why revenue buoyancy has been inadequate despite these reforms.

In the area of direct taxes the reforms have succeeded in establishing a regime of moderate tax rates
which compare reasonably well with other countries. 23. The maximum rate of personal income tax has
come down from 56% at the start of the reform to 30% in 1997-98. The rate of corporation tax on Indian
companies, which varied from 51.75% to 57.5% in 1991-92, depending upon the nature of the company,
has been unified and reduced to 35%. Despite these reductions in rates, revenues from personal and
corporate taxes have remained buoyant as indicated by the continuing increase in these revenues as a
per cent of GDP (Table 6). The share of direct taxes in GDP is still too low, but it has increased steadily
over time from 2% in 1990-91 to 3.5% in 1997-98. On the whole, this appears to be an area where the
strategy of reform seems to be working fairly well and needs to be continued, with special emphasis on
broadening the tax base and improving compliance by reducing under-reporting of taxable income.

24. Customs revenues declined steadily as a percentage of GDP in the initial years and then stabilised at
a lower level. In view of the explicit intention The maximum rate which was as high as 250% before the
reforms, has been reduced to 40% in 1997-98, and duty rates below the maximum have also been
reduced and rationalised. of reducing levels of protection in the economy, the loss of revenue from
customs duties is not unexpected and should be viewed as an acceptable cost of tariff reforms. As
argued later in this paper, customs duty rates have to fall further in future, which implies that this cannot
be a source of increasing the tax ratio in the years ahead. At best we can hope to avoid a further decline
in the ratio of custom duties to GDP despite a continuing decline in duty rates because the removal of
quantitative restrictions on consumer goods, which is a part of the reform agenda, will add to the
buoyancy of customs revenues as these imports are likely to be at the upper end of the duty rate
structure.

25. There has been less change in the tax structure in the case of excise duties thoughExcise duties are
a major source of indirect tax revenue in India and performance in this area has been unexpectedly weak.
Excise duties as a percentage of GDP declined from 4.4% of GDP in 1990-91 to 3.4% in 1997-98. Had
the tax ratio increased over this period, as it should have in view of the fact that the industrial sector,
which is the base of excise duties has grown faster than GDP, the fiscal deficit would have been
significantly lower. The reasons for the poor performance of excise duties need to be carefully studied so
that corrective action can be taken.

Ideally, the domestic indirect tax system should have been converted into a full fledged VAT which
integrates the tax system from manufacturing down to retail sales, creating a self re-inforcing chain of tax
compliance. Experience in other countries shows that a shift to VAT would help improve revenue
generation but this is not possible in India under the present constitutional division of powers, whereby
excise duties at the production stage are levied by the Central Government while sales taxes at the
wholesale or retail level are levied by the States. In the absence of VAT, India had introduced a modified
VAT (called Modvat) under which credit was given for excise taxes paid on inputs against excise taxes
due on outputs. thus avoid cascading of excise duties. This system was extended and rationalised during
the reforms in various ways. The number of duty rates has been reduced and some exemptions removed.
The tax credit facility (Modvat facility) was earlier not available for all products and is now almost has now
been made almost universal in coverage. Earlier, credit was given only for duties paid on inputs but since
1995 it has been extended to duties paid on capital goods. The number of duty rates has been reduced
and some exemptions removed. These efforts at rationalising the excise duty structure were expected to
lead to a rising share in the ratio of excise revenue to GDP but in fact excise revenues have declined
steadily.

It is possible that expansion of the Modvat facility to all goods, including capital goods, as part of the tax
reforms was not accompanied by a sufficient increase in excise duty rates on final products to maintain
revenue buoyancy. In a system with full tax credit being given for all inputs and for capital goods, excise
revenue mobilisation (net of Modvat credit) depends upon the revenue realisation from excise duties on
final consumption. Unfortunately, India’s excise duty structure contains too many consumer products
which are either exempted from excise altogether or attract relatively low rates of duty. Tax reformers
usually recommend a tax structure characterised by a single duty rate, with additional duties to be levied
on luxury items, as most likely to improve tax compliance and to increase revenues Even if a single rate
proves difficult to implement immediately, it is desirable to move to a rate structure with at most three
rates as soon as possible. However, this implies an increase in excise duty rates for a large number of
currently low taxed consumer items. It is necessary to create public awareness that across the board
increases of this sort, implemented as part of a strategy of rationalisation in which other tax rate are
reduced, does not increase the burden of taxation on the average commoner.

3. Structural Reforms

India’s efforts at structural reforms covered the familiar gamut of decontrol of private investment, opening
up the economy to foreign trade and foreign investment, financial sector reforms, etc. This familiar
package of market oriented reforms was supplemented by efforts to strengthen various anti-poverty
programmes reflecting a widely shared perception that liberalisation by itself would not provide an
adequate flow of benefits to the poorest sections of the population at least in the short run. In this section
we evaluate the extent of change actually implemented in the critical areas of structural reform, indicating
the degree of consensus on each of these issues across the political spectrum. Multifaceted reforms also
raise issues of sequencing because the effectiveness of reforms in one area depends upon the
implementation of reforms in other areas. We touch upon these issues where they are especially
important, or have been the focus of public debate.

a] Removing Controls on Private Investment

India’s industrial environment before the reforms was characterised by pervasive government controls on
private investment which prevented entrepreneurs from responding quickly and flexibly to market signals.
Reducing these controls was essential to create a more competitive industrial environment and this part
of the reform agenda - broadly described as domestic liberalisation - . This aspect of the reforms enjoys
the widest possible political support across parties. Major progress has been made in this area as far as
Central Government controls are concerned.

Industrial licensing was a major instrument of control under which Central Government permission was
needed for both investment in new units (beyond a relatively low threshold) and also for substantial
expansion of capacity in existing units. Licensing was undoubtedly responsible for many of the
inefficiencies plaguing Indian industry. In a series of steps, licensing was abolished for all except 6
industries viz. alcoholic beverages, cigars and cigarettes, electronics, aerospace and defence products,
hazardous chemicals and pharmaceuticals. Another major achievement was the abolition of the special
permission needed under the MRTP Act for any investment by the so-called "large houses". This was an
additional instrument of control over large private companies or companies belonging to large groups, in
addition to industrial licensing. Its stated objective was to prevent "concentration of economic power" but
in practice it only served as another barrier to entry, reducing potential competition in the system.
Abolition of these controls has given Indian industry much greater freedom and flexibility to expand
existing capacity, or to set up new units in a location of their choice, thus increasing the pressure of
competition as well as the ability to face competition.

Major progress has also been made in opening up areas earlier reserved for the public sector. At the start
of the reforms 18 important industries, including iron and steel, heavy plant and machinery,
telecommunications and telecom equipment, mineral oils, mining of various ores, air transport services,
and electricity generation and distribution, were reserved for the public sector. This list has been reduced
to 6, covering industries as arms and ammunition, atomic energy, mineral oils, atomic minerals and
railway transport. Because of this liberalisation, private investment including foreign investment has
flowed into areas such as steel, telephone services, telecommunications equipment, electricity
generation, petroleum etelecommunications equipment, electricity generation, petroleum exploration
development and refining, coal mining and air transport, none of which would have been possible earlier
because of public sector reservation.

An important area where decontrol domestic liberalisation has made very little progress is relates to the
the policy of reserving certain items for production in the small scale sector defined in terms of a
maximum permissible value of investment in plant and equipment. The policy "protects" small scale units
by barring the entry of larger units into reserved areas also prevents existing small scale units from
expanding beyond the maximum permissible value of investment. India is unique in adopting reservation
as an instrument for promoting small scale producers and Thethe policy obviously entails efficiency
losses and imposes costs on consumers. Several committees have recommended various degrees of
dilution of the reservation policy. Most recently, an Expert Committee on Small Enterprises set up in
1995, has recommended that reservation should be completely abolished and efforts to support small
scale producers should focus instead on positive incentives and support measures. None of the
governments in the post-reforms period has been inclined to accept a drastic re-orientation of policy along
these lines. The United Front Government in 1997 mitigated the rigours of reservation by raising the
investment limit for small scale industries from Rs.60 lakhs to Rs.3 crores. It also removed 15 items from
the reserved list. The successor BJP led government has announced the de-reservationed of farm
implements in 1998.

Many of the items on the reserved list are such as would in any case be produced in the small scale
sector so that reservation does not impose significant cost on the economy. However, a reconsideration
of the reservation policy is urgently needed in areas such as garments, toys, shoes and leather products.
These are areas with a large export potential but reservation prevents the development of domestic units
of the size and technology level which can deliver the volumes and quality needed in world markets.
Some flexibility was introduced in 1997 ______ by allowing larger units to be set up in these sectors
provided they accept an obligation to export 50% of production. It remains to be seen whether this
modification will provide sufficient incentive to encourage producers to set up larger capacities to tap
export markets.

While Central Government controls on investment have been greatly liberalised except in the matter of
small scale reservation, little has been done about controls at the State level. Investors typically complain
of having to obtain a very large number of separate state government approvals relating to acquisition of
land, electricity and water connections, conformity with regulations regarding facilities to be provided for
labour, various safety and pollution related clearances etc. These controls generate harassment, delays
and petty corruption and are viewed as major impediments by both domestic and foreign investors.
Reforms to eliminate unnecessary controls at the State level are urgently needed to complement
decontrol at the Central level. Some State Governments are trying to streamline the system, and these
efforts are being spurred by the growing competition among States to attract both domestic and foreign
investment. However the situation varies from State to State and much more needs to be done in this
area.

b] Opening the Economy to Foreign Trade

Opening the economy to trade and foreign investment was an important objective of the reforms aimed at
reaping the potential benefits from greater integration with the world economy. Unlike the effort to reduce
controls on domestic industry, which enjoyed wide support, for which there is widespread support, there
was less consensus on external liberalisation. Spokesmen for Indian industry initially voiced strong
support for both domestic liberalisation and external liberalisation, especially liberalisation of access to
imports of components and capital goods. As tariff levels came down and the pressure of competition
from imports increased, concern began to be expressed about the need to provide an adequate transition
period for domestic industry to adjust to external liberalisation, in particular the need to create a "level
playing field" by first removing domestic policy constraints afflicting domestic firms, which made it difficult
for these firms to become competitive. This was sometimes expressed as an issue of sequencing, in
which it was argued that domestic liberalisation must precede external liberalisation. While the debate on
these issues continues, a . Despite these doubts a substantial consensus of sorts has evolved in favour
of a gradualist process of external liberalisation. Significant progress has been made towards this
objective over the past seven years. by removing quantitative restrictions and lowering tariff barriers,
though the process is not yet complete. .

i] Dismantling Quantitative Restrictions

India’s trade policy regime before the reforms was heavily dependent upon the use of quantitative
restrictions(QRs) in the form of import licenses, more than almost any other developing country. Imports
of finished consumer goods were simply not allowed and even inputs into production such as raw
materials, components and capital goods were subject to restrictions through import licensing. The
system began to be administered more liberally in the 1980s, with import licenses being much more freely
given, but it remained restrictive and also highly discretionary. The first phase of dismantling QRs
occurred in the first two years of the reforms when import licensing was virtually abolished for imports of
industrial raw materials, intermediates, components and capital goods. By 1993, these categories could
be imported freely, subject only to the prevailing tariff levels. However, agricultural products and industrial
consumer goods remained subject to import controls. Import restrictions on agriculture were probably
redundant as India’s agricultural product prices were typically lower than import prices and agriculture
actually suffered from negative protection via export controls. Restrictions on imports of consumer goods
on the other hand provided substantial and open ended protection for all industrial consumer goods ,
which account for about 25 per cent of the manufacturing sector in terms of value added.

Continuing with near infinite protection for consumer goods while liberalising other imports has been
widely criticised as illogical because it only distorts resource allocation in favour of highly protected
consumer goods industries and away from basic and capital goods industries which are otherwise
thought to be "strategically" important. This was recognised at a policy level and the need to extend
import liberalisation to consumer goods as part of the reforms was explicitly stated in the Eighth Plan as
early as 1992, but implementation of this element of trade policy has been very slow because of
perceived political sensitivity. Predictably once the balance of payments improved, the QR regime was
challenged by India’s major trading partners as inconsistent with the WTO. This led to protracted
negotiations which culminated in the United Front announcing, in 1998, a plan to phase out QRs on all
imports within a period of six years. This was accepted by all the major trading partners except the US.
The phase out will occur in three stages with most QRs being phased out in the first 3 years while QRs on
agricultural products will be phased out only at the end of the period. The commitment to phase out QRs
has been endorsed by the BJP Government which took the first step in thuethe process by removing QRs
on 350 items in April 1998. This still leaves about 2200 items subject to QRs to be removed over the next
six years. In August 1998, the government unilaterally removed QRs on 2000 of these items for imports
from the SAARC region countries in order to give a boost to trade liberalisation in the region.

ii] Reducing Tariffs

India’s trade policy before import duties before the reforms was characterised by import tariffs which were
among the highest in the world. Rates with duty rates above 200% were being fairly common. Significant
progress has been made in reducing tariff rates since then. The maximum tariff rate was brought down in
a series of steps to 45% in 1997-98 (Table 7). Tariff rates below the maximum have also been lowered
over the years, bringing the import weighted average tariff rate for all products down from 87% in 1990-91
to 30% in 1998-99.

Customs duties were steadily reduced in the first five years. Duties continued to be lowered on a number
of items in 1996 and 1997 but this was offset to some extent by the imposition of a 2% surcharge on most
imports in 1996, as a revenue raising measure, followed by another 3% surcharge in 1997 to finance the
burden of the large civil service pay rise announced in that year. The Budget for 1998-99, presented by
the new BJP Government, introduced some changes in customs duties an entirely new special customs
duty. Several industry associations had complained of the lack of a level playing field on the grounds had
complained that domestic producers were subject to certain local taxes, which were not balanced by
equivalent taxes on imports in the same way as excise duties on domestic production are balanced by an
equivalent "countervailing duty" duties levied on imports. It was argued that these local taxes had the
effect of reducing the protective element in the existing duty structure, and in certain cases where
customs duties were low, the erosion was said to result in a complete elimination of protection.
Responding to these demands, a special additional duty on imports to balance the incidence of local
taxes was levied initially at 8% but quickly reduced to 4%. This duty was widely criticised as signalling a
retreat into protectionism, a charge vociferously denied by the government which pointed to the fact that
the 1998-99 Budget also reduced customs duties on a number of products, and in this respect continued
the trend of tariff reduction of earlier yearswhich indicates.also The deadline for zero duty treatment of a
number of electronic products, agreed to under the Information Technology Agreement-1, was also
advanced by two years, which indicates signalling an acceleration of the process of opening up in this
area.

Despite the new duties introduced in the past two years, the average rate of duty is much lower than in
1990-91 (Table 7). However, average tariff levels in India are much higher than in other developing
countries, where tariff rates typically range between 5 and 15%. Since consumer goods continue to be
protected by QRs, the tariff levels understate the degree of protection for these items. The process of
reducing tariff levels clearly needs to continue to complete the reform process in this area.

Tariff reform in future must also focus on the problem of tariff inversions, whereby duties on final products
are lower than duties on inputs thus giving rise to very low or even negative protection in some cases.
The duty on various types of steel for example is 30 to 35% whereas the duty on capital goods ranges
from 20 to 25% and is even zero in some cases. Such tariff inversions did not matter the earlier system
because of quantitative restrictions on imports of the final product but they obviously become very
important once QRs are phased out. The problem has arisen in part because tariffs on many intermediate
inputs were relatively high to begin with and the gradualist pace of reduction has left many of these tariffs
at too high a level, while other tariffs have been reduced more rapidly.

There is also a case for a pre-announced time table for future tariff reductions. The Congress
Government had indicated that tariffs would be brought down to levels "comparable with other developing
countries" but had not specified either the final structure of tariffs or the time frame for reaching it. The
United Front government stated that it would move to Asian levels of tariffs by the year 2000 but the exact
tariff structure was left undefined except in the case of hydrocarbons where a terminal year structure for
2002 has been indicated and for information technology related products where India has accepted the
ITA-1 commitments. The BJP led government has stated that it favours "calibrated globalisation" which
implies that the process of reducing tariffs will continue, but again no specific time frame has been spelt
out. A clearer indication of target levels of tariffs over the next three to five years would help investors
making decisions on new investments.

To summarise, India’s tariff reduction programme, though still incomplete, has certainly created a more
open economy, with significant beneficial effects as Indian firms are being pushed to restructure their
operations to become more competitive. The fact that protectionist noises from some segments of
industry, have increased in recent years indicates that this process is beginning to bite. Banks and
financial institutions are also increasingly assessing the viability of new projects on the basis that the
economy will continue to open up and tariffs will be reduced further. The pace of the transition has been
slow, consistent with the gradualist strategy, and it is necessary to continue lowering tariffs, focussing
especially on tariff inversion problems. Fortunately the present levels of duty are now in the range where
the remaining adjustment can be completed in two or three years.

iii] Exchange Rate Flexibility

The removal of QRs and reduction in tariff levels described above would not have been possible but for
parallel changes in exchange rate policy. The rupee was devalued in July 1991 by 24% as part of the
initial stabilisation programme, and a dual exchange rate was introduced in March 1992. The dual
exchange rate was unified shortly thereafter in March 1993 and the unified rate was allowed to float. The
cumulative effect of these changes was that between June 1991 and March 1993 the exchange rate
depreciated from $1=Rs.20 to $1=Rs.31, a depreciation of 35% in the dollar value of the rupee and a real
depreciation (adjusting for price changes) of around 27% vis-�-vis India’s major trading partners. This
adjustment in the exchange rate clearly helped Indian industry to meet the import competition resulting
from trade liberalisation.

The flexible exchange rate regime has worked reasonably well with the exchange rate responding to
market conditions while the Reserve Bank of India (RBI) intervenes periodically through foreign exchange
sales and purchases or through monetary fine tuning to "maintain orderly market conditions". Exchange
rate management has avoided the danger of excessive rigidity and also the opposite dangers of
overshooting with associated loss of confidence. Although there is no declared real effective exchange
rate target the system has worked in a manner to preserve the advantageous real exchange rate
achieved in the early years of the reforms. As shown in Figure 1, the real exchange rate depreciated
sharply at the start of the reforms, and appreciated thereafter in 1994-95 and 1995-96, but this
appreciation in the real exchange rate was corrected in subsequent years, bringing the real effective rate
close to the level reached in 1993-94.

As part of the process of transiting to an open economy India declared full current account convertibility in
1994 and accepted the corresponding obligations of Article VIII of the IMF. Following this decision a
number of steps have been taken to liberalise exchange restrictions on current account transactions. The
United Front government in 1997 announced that the Foreign Exchange Regulation Act of 1973 would be
repealed and replaced by a more modern Foreign Exchange Management Act (FEMA) but the
Government fell before this could be done. It is a measure of the continuity in policy that FEMA was
subsequently introduced in 1998 by the successor BJP led coalition.

c] Policy towards Foreign Investment

The reforms involved a radical re-orientation of foreign investment policy with foreign investment being
actively sought not only as a preferred means of financing balance of payments deficits compared with
external borrowing, but also because it provides access to closely held technology and to global
marketing linkages. Both foreign direct investment (FDI) and portfolio flows have been encouraged in the
post-reform period with good positive results in both cases.

The process of approving foreign direct investment (FDI) was expedited by providing a window of
automatic approval of FDI upto 51% foreign equity in a defined list of 48 industries and upto 74% for 9
high priority industries. Foreign investment proposals which are not eligible for the automatic route can
obtain approval from an inter-Ministerial body called the Foreign Investment Promotion Board (FIPB).
Approvals from FIPB are generally seen to have been speedily and liberally given. Despite widespread
concerns about the BJP’s attitude to foreign investment, the new government has continued this system
and has announced its intention to expedite clearances and also set up mechanisms to help translate
approvals into actual investment decisions.

The results achieved by the new policy are summarised in Table 8. Total approvals for FDI have
increased from $325 million in 1991-92 to $16 billion in 1997-098. Actual inflows are running atof course
much lower, level reflecting the lag in converting approvals between approvals andto inflows, but even
these have increased from a negligible level of $133 million in 1991-92 to over $3 billion in 1997-98. This
may not appear impressive compared to the volumes attracted by many other countries, but it represents
a dramatic increase from the earlier levels prevailing earlier and it is growing. The change in the foreign
investment environment in India is reflected in the fact that a large number of Indian companies have
sought foreign joint venture partners while major foreign investors have focussed on India for the first
time. The latter category includes several of the Fortune 500 companies such as General Motors, Ford,
Merck, Sony, Honda Motor, Coca Cola, Hewlett Packard, Texas Instruments, LG International, Fanuc,
Samsung, Du Pont, AT and T, BT, Enron, Shell and a host of others. The amounts invested in most
cases are as yet small, but the entry of such investors holds out the potential for substantially larger
inflows in the years ahead.

The economy has also been was also opened to portfolio investment in two ways. In 1993 Foreign
Institutional Investors (FIIs) meeting certain minimum standards were allowed to invest in Indian equity
and later also in debt instruments through secondary market purchases in the stock market. At present
528 FIIs are registered with the Securities and Exchange Board of India (SEBI) and around 150 are active
investors. A second window for portfolio investment was provided by allowing Indian companies to issue
fresh equity abroad through the mechanism of Global Depository Receipts (GDRs). This enabled Indian
companies to raise resources from passive investors in world markets instead of seeking active investors
as is the case with joint venture partners. Portfolio investment has expanded rapidly in the post-reform
period. From a level of $ 4 million in 1991 the inflow on account of FII flows and GDRs taken together
quickly increased to $3.6 billion in 1993-94 and fluctuated thereafter. It declined to $1.5 billion in 1997-98
reflecting the effect of the Asian crisis on capital flows to emerging markets. Despite the often expressed
concern about the volatility and unreliability of portfolio capital flows, India’s experience in this area has
been fairly encouraging. Inflows of portfolio capital have fluctuated but they did not turn negative even in
1997-98 during the East Asian crisis. The cumulative inflow of portfolio capital since the reforms began
exceeds $15 billion, a significant amount in absolute terms even if it is associated with some potential for
volatility.

While liberalising inflows of FDI and portfolio capital, other elements of the capital account remained
subject to controls though the controls were more flexibly administered. Corporations and individuals
need government permission to borrow abroad and such permission is granted within a framework which
places a cap on total external borrowing and also ensures a minimum maturity period for each borrowing.
This policy has helped to control India’s exposure to external debt and in particular to avoid a build up of
short term debt which is viewed with particular disfavour in financial circles in the aftermath of the Asian
crisis. Foreign investors are allowed to repatriate dividends and capital freely but Indian residents are
restricted from taking capital out of the country, a restriction which makes it easier to avoid panic over-
reaction in foreign exchange markets.

In 1996, the government appointed a Committee on Capital Account Convertibility to advise on the
transition to full capital account convertibility. The Committee recommended moving to capital account
convertibility over time in a phased manner, but emphasised that certain pre-conditions must be
established first. These include a moderation in the rate of inflation, a reduction in the fiscal deficit to 3%,
and also considerable strengthening of the domestic banking system to deal with stresses created by an
open capital account. These conditions implicitly rule out any quick move to capital account convertibility.
The recent East Asian experience certainly suggests that there is merit in a cautious approach in this
area.

d] Reducing Price Controls

Reduction, if not elimination, of price controls is a familiar component of market oriented reforms
everywhere and this was the case in India also. Price control was abolished at an early stage of the
reforms in some key industries, viz., iron and steel, coal, phosphatic and potassic fertilisers, newsprint,
naphtha, lubricating oils and molasses . Price control on pharmaceuticals was not abolished but its
coverage was reduced in 1995 from 143 basic drugs to 76. However, price control remains in place in
three major areas, i.e., hydrocarbons, electricity and nitrogenous fertilisers, introducing significant
distortions in the system. Interestingly though price decontrol is clearly a part of domestic liberalisation
which enjoys wide support in principle, there is great reluctance across all parties to implement it in
practice.

i] Decontrol of Hydrocarbon Prices

The petroleum sector in India was fully state owned at the start of the reforms with the State also
controlling imports of crude oil and production. Prices were determined by a complex Administered Price
Mechanism (APM) under which domestic producers of crude and natural gas were paid controlled prices
which were much lower than world market prices. Refineries also received controlled prices for their
products based on the cost of crude oil supplied to them (either underpriced domestic crude or market
priced imported crude) plus a refining margin for each refinery based on plant specific refining costs.
Prices charged to consumers were also controlled and were expected to cover the cost of domestically
produced and imported supplies. However, there was substantial cross subsidisation across products,
with kerosene and diesel being underpriced, while gasoline and aviation fuel were over priced. The
inefficiencies in this system were extensive. Under-pricing of crude oil discouraged exploration. Cost
based product prices paid to refineries gave them little incentive to reduce costs. Severe underpricing of
kerosene led to pervasive black marketing and adulteration of diesel with kerosene. Since consumer
prices were not adjusted sufficiently frequently to reflect changes in the cost of imports, the system often
generated deficits in the oil sector accounts. The controlled price regime was particularly unsuitable for
attracting private investment in either production or refining since private investors expected an assured
structure of market related prices.

In a major decontrol initiative the United Front government in 1997 announced a phased de-regulation of
petroleum prices to be completed by 2002. The first step in 1997 was to fix the domestic consumer prices
of diesel, fuel oil and LSHS on the basis of import parity, with monthly adjustments to reflect changes in
import prices. Domestic crude oil and natural gas prices, as well as petroleum product prices paid to
refineries, will be progressively adjusted within an APM framework to reach import parity prices by the
year 2002 at which point they will be de-regulated. Import parity pricing for crude and products is feasible
only if the customs duty structure is rationalised to avoid anomalies in the present structure where the
customs duty on crude oil is higher than on many products. The government has announced a duty
rationalisation and the year structure of customs duties in this sector to be achieved by 2002 has been
published, though the annual phasing to reach that level has not been announced. Kerosene, which
meets the fuel and lighting needs of the poor, will continue to be subsidised, but this subsidy will be made
explicit and met from the Budget. Similarly naphtha, which at present is supplied at a subsidised price to
the fertiliser industry will be provided only at the normal decontrolled price, requiring either an increase in
fertiliser prices or an increase in the fertiliser subsidy from the Budget. The transfer of these subsidies to
the Budget will impose a severe fiscal burden but a successful transition to market prices in this important
sector will be a major achievement with significant efficiency gains.

ii] Control over Electricity Prices

Pricing of electricity is subject to regulatory control in most countries but the way it has operated in India
is seriously flawed. Electricity prices charged to consumers are fixed by State Governments and have
been set very low for certain categories of consumers such as households and agricultural users and this
is one of the major reasons for the poor financial condition of the State Electricity Boards (SEBs). The
SEBs are expected to earn a rate of return of 3% on capital employed but they actually earn a negative
rate of -13.7 per cent with total losses amounting to Rs.10,000 crores or about 0.8 per cent of GDP. This
is one of the main reasons why public investment in this sector has fallen below target. It is also the
reason why it is difficult to encourage private investment in electricity generation since private investors
are deterred by high risks of non-payment by financially weak SEBs which are the sole buyers.

A shift to a rational system of setting electricity tariffs is essential if investment in power, whether public or
private, is to take place. The primary responsibility for such reforms rests with the State Governments but
the Central Government has an important catalytic role to play. In 1995 the Congress Government
announced a National Minimum Action Plan for Power envisaging depoliticisation of electricity tariffs by
entrusting tariff fixation to an independent State Regulatory Commission with terms of reference which
would ensure that tariffs must cover costs and earn a 3% return. The Plan also sought to limit the extent
of price distortion through cross subsidy by stipulating that the maximum underpricing allowed to any
category of consumer should not exceed 50% of the cost of production nor should any consumer be
charged more than 50% above the cost of production. The successor United Front Government
introduced legislation to set up a Central Electricity Regulatory Commission but was not able to get it
passed by Parliament. The BJP government in 1998 was able to get Parliamentary approval for a
modified Central Electricity Regulatory Commission Act which sets up a Central statutory commission to
regulate all inter-state sales and transmission of electricity and set tariffs in such cases. The Act also
provides for separate State Regulatory Commissions to be set up by individual states which will regulate
the electricity sector within a State and fix all tariffs. Though the establishment of State level Commissions
is not mandatory it is heartening to note that as many as ten States are expected to enact the necessary
legislation setting up State level commissions. Another important step forward was the passage of the
Electricity Transmission Act which opened the transmission sector to private investment.

The process of reform in the power sector has made good progress in some States. Orissa was the first
to restructure its power sector by setting up a State level regulatory commission for fixing tariffs
and………………….. unbundling the monolithic SEB into separate generation, transmission and
distribution corporations. It is currently engaged in privatising distribution. A few others, Andhra Pradesh,
Haryana and Rajasthan are considering similar reforms. It is difficult to say as yet how fast these changes
will be implemented in other States, but there is no doubt that the process has begun.

iii] Price Controls on Nitrogenous Fertiliser

Nitrogenous fertiliser is another important industry where prices continue to be fully controlled. Fertiliser
factories are paid a cost based plant specific producer price, and the government fixes a low consumer
price for farmers. The difference between producer and consumer prices is met by a budgetary subsidy
which amounts to about 0.7% of GDP. The inefficiencies of the system have been noted by many critics.
The cost based producer price system provides insufficient incentive for cost reduction and under pricing
of nitrogenous fertilisers for farmers is leading to wasteful use of fertilisers and a distortion in the N:P:K
ratio compared to the agronomically recommended norm. The resources absorbed by the subsidy have
also increased consistently over time and it has been argued that the same resources would be far more
beneficial to agriculture with superior distributional effect if directed to increase public investment in
irrigation and other agriculture related infrastructure. While these concerns are well recognised, it has not
been possible to change the system of pricing nitrogenous fertilisers.

e] Labour Market Controls

An important area untouched by reforms thus far is the labour market. India’s labour laws, which apply to
all industrial units employing more than 100 persons, make it difficult for firms to either shed excess
labour or to close down unviable units. Indian firms complain that labour market rigidities make it difficult
to achieve the levels of efficiency and competitiveness needed to survive in the more competitive and
more open economic environment. They also discourage entrepreneurs from investing in relatively labour
intensive areas, which not only reduces employment below its full potential but also introduces an
additional bias against exports since India’s exports are typically at the labour intensive end of the
spectrum.

Labour rigidities also make it difficult for Indian companies to undertake much needed restructuring.
Indian companies in the past were encouraged to enter into diverse lines of production outside their areas
of "core competence", often setting up plants of sub-optimal scale because the industrial environment
provided assured protection from international competition with very limited domestic competition. In the
new more competitive environments these companies need to consolidate their position in core areas,
where they must modernise and expand, while selling off other units to other entrepreneurs in a better
position to manage and modernise them. Such restructuring should normally take place through mergers
and acquisitions, but it is more difficult in India because potential new owners are unwilling to take over
existing units if they are burdened with surplus labour. They would rather set up a new unit, even though
restructuring may be much cheaper if labour laws were less rigid.

It is sometimes argued that labour problems in India are exaggerated by inefficient managements as an
excuse for management failures. Certainly, many well run firms have been able to shed excess labour
through generous voluntary retirement schemes. The costs incurred are significantly higher than the
statutory minimum compensation payable under the law, but this only reflects the fact that the statutory
compensation requirements are very low. Restructuring through mergers and acquisitions has also
become more common, especially after 1996. The attitude of labour unions has also changed
considerably because of competition in product markets. Labour intransigence beyond a point in a
competitive market situation only weakens the unit relative to its competitors and therefore militates
against the interest of the labour employed in the unit. However, these factors do not negate the case for
more rational labour laws. On the contrary, as protection levels are lowered further in future, Indian
industry will need all the possible efficiency gains it can achieve to be internationally competitive and
greater flexibility in the labour market will be an important pre-requisite to achieve this goal. This is an
area in which there is very little consensus anywhere in the political spectrum at present, but such a
consensus will have to be developed.

f] Public Sector Reforms

Despite suffering from all the familiar problems experienced by other developing countries with a large
public sector, the approach to public sector reforms in India’s approach to public sector reforms has been
much more cautious than elsewhere that of other developing countries. Radical solutions such as outright
privatisation of commercially viable units and closure of unviable units, which have been attempted in
many countries elsewhere, were eschewed to begin with, in favour of a much more cautious approach. In
the 1980s public sector reform focussed on increasing the functional autonomy of public sector
organisations to improve their efficiency. In the 1990s this was combined with "disinvestment" involving
sale of a portion of the government equity in public sector enterprises while retaining majority control with
the government attempting to improve the performance of public sector enterprises (PSEs) as much as
possible without rejecting public ownership as an inherently inefficient arrangement. Nevertheless p.

Unlike privatisation a la Margaret Thatcher, which was driven by the conviction that government control
makes public sector units inherently less efficient and privatisation therefore improves economic efficiency
and is good for the consumers, 59. Since the late 1980s efforts to reform the public sector have focussed
on granting PSEs greater functional autonomy from the government to enable them to function as
commercial enterprises. The need for more autonomy is indisputable. Public sector enterprises in India
operated under a suffocatingly large number of guidelines laid down by government over the years many
of which has lost their relevance but were never withdrawn. Many critical decisions taken by PSEs,
including investment decisions, needed separate approval by the government. Complete independence
from government in a situation where the government owns the company, appoints the Chief Executive
and is responsible to Parliament for the actions of PSE managements is impossible. However, steps have
been taken to give PSEs greater operational freedom. Almost 700 guidelines accumulated over the past
several years were withdrawn. Nine of the best performing public sector units have been given special
status, with greater delegation of financial power to make investments, enter into strategic alliances, raise
capital from the capital markets, etc. without seeking government approval. The Boards of these PSEs
are proposed to be broad based by appointing non-government directors with the objective of making
these PSEs truly Board managed companies in due course.

The second leg of the strategy for public sector reform was partial privatisation under which a portion of
government equity (initially limited to 49%) would be sold to private investors. This was the policy of
disinvestment in India was initially motivated largely by the need to raise resources for the Budget. Equity
sales took place intermittently through the post reform years, and by 1997-98 the government had sold
varying proportions of equity, ranging from 5% to 49%, in 50 public enterprises, generating a total
revenues of of over Rs.8400 crores in the processfor the Budget. Partial privatisation of this type can be
legitimately criticised on the grounds that it is unlikely to yield the efficiency gains associated with full
privatisation including transfer of management. However, it needs to be recognised that even the
induction of minority private shareholders makes some difference. It rules out budgetary subsidies to the
enterprise, which is an important improvement in incentive system. Public sector managers in partially
privatised PSEs become much more conscious of market indicators of performance such as earnings per
share, dividends and share prices, and this creates greater commercial orientation. Many public sector
units also acquired private investors, including international portfolio investors by making fresh issues of
equity in international markets for the purpose of raising funds for their expansion programmes. The
presence of international stakeholders has helped create a climate in which PSE managers are able to
extract greater de facto autonomy from the government.

Over time, the insistence on maintaining government control in public sector enterprises was steadily
diluted and a broader consensus evolved towards eliminating government control in some areas. The
United Front Government. I in 1996, established a Disinvestment Commission was appointed charged
and specifically requested the Commission to identify units in "non-strategic and non-core" areas where
the government stake can be reduced to a minority or even zero. The Commission has examined 50
public sector enterprises and recommended disinvestment of a majority stake, with transfer of
management control, in several cases. Implementation of these recommendations has been slow, but
effective privatisation in a few PSEs, with a majority stake and effective management control being
offered to private sector investors now appears very likely in 1998-99. This clearly heralds a very different
approach to public sector reform and this approach has been further reinforced by the BJP government’s
announcement that the government stake in public sector enterprises will be reduced to 26% "in the
generality of cases".

62. It is difficult to evaluate whether these efforts to improve the performance of the public sector have
made a difference in practice. Available data on the financial performance of the public sector enterprises
in the post-reform period are summarised in Table 9. They clearly show that the profitability of all public
sector enterprises as a whole has improved significantly in the post-reform period. Gross profit (before
deduction of interest) as a per of cent of capital employed was 10.9% in 1990-91 and increased to 16.1%
in 1995-96. Since the economic environment became much more competitive over this period, it is
reasonable to assume that increased profitability reflects improvements in operational efficiency.

The area of public sector reforms where very little has been done relates to the treatment of chronically
loss making public sector enterprises making losses. While some of these units can be turned around,
many have been making losses for a very long period of time and are unlikely candidates for revival. The
government ruled out sSummary closure of these units and was ruled out in the early years of the reforms
and the government decided instead that the scope for reviving each unit would be carefully examined
and only those units where revival was found to be economically feasible would be revived while others
would be closed down. The feasibility of revival was to be determined by the Board for Industrial and
Financial Reconstruction (BIFR) and government would take a decision based on the Board’s
recommendations. Several public sector units have been identified as fit for closure through this process,
and the government has even decided on closure in many cases, but no unit has been actually closed
because the decision has been challenged in the courts by labour unions. The BJP Government in its first
Budget announced a generous retrenchment package to be offered in cases of closure in order to
overcome labour opposition.

Has this combination of partial privatisation, combined with some effort to increase public sector
autonomy, led to improved performance of the public sector? Available, data on the financial performance
of the public sector enterprises in the post-reform period (Table 9) show that the profitability of public
sector enterprises as a whole has improved significantly in the post-reform period. Gross profit (before
deduction of interest) as a per of cent of capital employed was 10.9% in 1990-91 and increased to 16.1%
in 1995-96. Since the economic environment became much more competitive over this period, it is
reasonable to assume that increased profitability reflects improvements in operational efficiency.

As in so many other areas of structural reform, it seems reasonable to conclude that a process of public
sector reform has clearly begun and the scope of what is feasible is now seen to be much wider than was
the case initially. Bolder efforts at privatisation of the public sectors are called for, not only to mobilise
larger volumes of resources which would help reduce the fiscal deficit but also to generate greater
efficiency in the public sector.

g] Private Investment in Infrastructure

It was recognised early in the reforms that a faster growing economy would need major investments in
infrastructure and these investments could not be financed solely in the public sector. Private investment
to supplement the public sector efforts was seen as the solution and new policies were announced to
encourage private investment (including foreign investment) in power generation, telecommunications
services, ports and roads. There has been some success in this area but the results thus far have fallen
considerably short of expectations. In retrospect it is clear that the difficulties in attracting private
investment into regulated sectors such as infrastructure were underestimated. Infrastructure sectors have
many special characteristics. Tariffs are controlled and public interest issues are invariably involved.
Private investors have to deal with a number of government agencies and are also subject to their
regulatory control to a much greater extent than elsewhere. In these circumstances, special efforts are
needed to create a policy environment in which good quality private investors will be encouraged to
invest.

The experience of private investors in power and telecommunications provides many examples of
problems which could have been avoided if the policy framework had been designed to deal with these
difficulties.

The early power projects were criticised on the grounds that the cost of private power was too high. This
criticism gained credibility because tariffs were fixed on the basis of a cost plus formula which inevitably
attracts the charge of cost padding. It could have been avoided if tariffs had been determined on the basis
of competitive bidding, as was done later.

Private sector power producers wanted fuel supply contracts which protected them from risks of fuel
supply interruption by providing for sufficient compensation in the event of non-performance by either the
public sector coal supplier or by the railways which have to transport coal to the power plant. Such
contracts had never been signed for coal supplies to public sector projects and there was reluctance on
the part of public sector suppliers to accept new obligations for private sector projects. The power policy
had not anticipated the need to mitigate fuel supply risk.

Private sector telecommunications projects could not achieve financial closure because lenders insisted
that in the event of debt service default by the original licensee, the telecom license should be assignable
at the option of the lenders to a new operator. The terms of the license under Indian law did not provide
for easy assignability and new provisions had to be devised to meet these requirements. This was an
important source of delay in implementation.

Private sector telecom operators claimed that the interconnection charges levied by the public sector
network were too high making it impossible to the new operators to compete with the existing public
sector operator. In this connection they complained that the regulatory framework was inadequate
because the Government was both the regulator and the owner of the public sector network. Private
operators demanded the establishment of an independent regulatory authority to adjudicate on disputes
with the public sector network. This demand was conceded and the Telecommunication Regulatory
Authority of India was established in 1996 . This has helped increase confidence levels but the scope of
its authority is narrower then the private operators would like.

Cellular licenses were awarded through competitive bidding on the basis of the license fee bid.
Subsequently market demand proved to be less then anticipated making these projects unviable at the
agreed license fees. The licensees have appealed to the government for an adjustment of the license
fees and an extension of the period of the license. The government is considering whether such
adjustments can be made at this stage consistent with the public interest and how to ensure transparency
if this is to be done. In retrospect, a revenue sharing arrangement would have provided a better method
of protecting against the downside of market risk.

68. TThese problems illustrate the fact that a great deal of preparatory work is necessary if private
investment is to play a significant role in infrastructure development. In particular, it is necessary to have
much greater clarity about the regulatory framework within which the private sector will operate. The aim
should be to create as close to a competitive situation as possible, with an unbundling of risks so that
private operators can take on only those risks which it is reasonable to expect them to take. Since the
complexity of these problems was not fully realised when the policies were initially introduced, there was
a great deal of "learning by doing".

Fortunately, some learning has taken place and many the process of private sector infrastructure projects
have taken off successfully. The first two private sector power projects are now in commercial production
and several others are at various stages of implementation construction. Private telecommunication
services (both cellular and basic) have commenced in various parts of the country. A major expansion of
the Jawaharlal Nehru Port at Mumbai involving doubling of the container handling capacity is being
implemented on a BOT basis by a private consortium. Several minor ports are being built entirely in the
private sector. Roads are the most difficult area for private investment, but a few small private sector toll
road projects are being implemented, while other larger projects are being planned for the future. The
extent of progress in this area can be seen from the figures for total loan approvals for private
infrastructure projects by the All India Financial Institutions which have increased from Rs.5880 crores in
1995-96 to Rs.22,255 crores in 1997-98. The disbursement figures also show an increase from Rs.2332
crores to Rs.6505 crores in the same period.

h] Reforming the Financial System

Reforms in the financial system are critical for the success of sStructural reforms if only because the
latter aim at reallocating real resources in the economy and this process needs to be supported lubricated
by an efficient financial system. I The efficiency of the financial system is especially important in the
context of the increasing integration of domestic and financial markets as is evident in the recent East
Asian experience, where weaknesses in the financial systems are now seen to be an important cause of
the currency crisis that engulfed the region. India’s reform programme therefore included a concerted
effort to reform banking and capital market institutions. There has been steady forward movement in
these areas. These reforms were to be extended to the insurance sector, but this has not yet taken place.

i] Banking Sector Reforms

71 Banking sector reforms were first initiated in 1992, based on the recommendations of the Committee
on the Financial System (Narasimham Committee), and the first stage focussed on interest rate
liberalisation, improvement in prudential norms and standards, strengthening supervision, and increasing
competition in the banking sector. In 1997, the United Front government appointed a second Committee
on Banking Sector Reforms also under the chairmanship of M. Narasimham to review what had been
accomplished and to chart the agenda for a second stage of banking sector reforms. The second
Narasimham Committee submitted its report in 1998 and its recommendations are expected to guide
banking reforms in the years ahead.though much more remains to be done.

72 The pace of banking sector reforms exemplifies gradualist change. The achievements thus far are
substantial though a great deal remains to be done.

In 1991, iInterest rates were have been almost completely de-controlled since 1991 when both. T the
interest rate on government debt as well as the deposit and lending rates of the commercial banks were
strictly controlled. was artificially fixed at a low level, supported by mandatory requirements for banks and
insurance companies to invest high proportions of their assets in government securities. The banking
system was also subject to strict interest rate regulation. The Reserve Bank of India (RBI) prescribed the
structure of deposit rates for term deposits of different maturities, and also the structure of lending rates
with different rates for different categories of borrowers. There has been a major liberalisation in this area.
Mandatory requirements for investment by banks in low interest government securities have been sharply
lowered and interest rates on government securities are now determined by the market on the basis of
periodic auctions conducted by the RBI. Deposit rates have been completely deregulated and lending
rates have also been largely deregulated, except for two a concessional rates for loans below Rs.25,000
and loans between Rs.25,000 and Rs.200,000.

3India made a relatively early beginning, compared with other developing countries, in upgrading
Pprudential norms and standards relating to capital adequacy, income recognition, asset classification
and provisioning have been upgraded and brought into closer alignment with, in line with the Basle
Committee recommendations, and enforced full compliance over a 3 year period. These standards have
been fully applicable since 31st March, 1996. The second Narasimham Committee has recommended
further tightening of these norms to ensure full alignment, and this will be done in phases.

External supervision of the banks has been strengthened to monitor and evaluate bank performance on
the basis of the new prudential standards. This has made the financial condition of the banks more
transparent focussing attention on the size of the non-performing assets (NPAs) of the banking system.
Performance in this area has been encouraging. The net NPAs of public sector banks as a proportion of
their commercial advances declined from 16.3% to 9.2%.

4 The degree of Ccompetition in the banking system has been increased significantly as new private
sector banks have been given licenses and foreign banks have been allowed to expand much more
liberally than in the past. The share of business of private sector banks and foreign banks has increased
from around 10.6% in 1991-92 to 17.6% in 1996-97. Public sector banks still dominate the system, but
greater competition among public sector banks is beginning to make an impact on their behaviour.

These reforms are already changing the way banks function. Higher prudential standards are forcing the
banks actively to seek quality borrowers in order to improve their asset quality. Interest rate liberalisation
gives the banks flexibility to offer borrowers more attractive interest rates. Quality borrowers on their part
are also able to demand better terms because of competition among banks and because the opening up
of both domestic and foreign capital markets, enables them to look for cheaper sources of funds outside
the banking system. All of this adds to competitive pressure favouring better In short, better regulation
and competition is working to the advantage of better quality borrowers which should improve the
allocative efficiency of the system.

5 However, the reforms still have a long way to go. As pointed out above the existing prudential norms
need to be further tightened and fully aligned with international practice. More importantly, reforms in
banking are about changing the way banking institutions function. A liberalised and more open economy,
with freer flow of capital, will place particularly heavy demands on the system. Bank margins will be
threatened as better quality clients gain access to other sources of funds especially in international
markets. Banks will have to develop much stronger credit appraisal skills than were necessary in the past
to reflect the more competitive environment facing borrowers and the consequent higher risk of failure. A
liberalised economy also involves exposure to greater volatility in both exchange rates and interest rates
and credit appraisal techniques must take account of the impact of uncertainties on these counts on the
quality of the loan portfolio. Static measures of asset quality need to be supplemented by methods of
assessing asset quality in the face of uncertainty. Handling these challenges calls for basic restructuring
of management systems in banks and massive upgradation of staff skills.

The next stage of banking sector reforms also requires parallel improvement in the legal system relating
to debt recovery. Efficient banking requires a credible threat of legal action to force recovery from
defaulting borrowers. Without such a threat, the incentive system encourages borrowers to default. India’s
legal system in these areas needs massive improvement. The government has recognised the need for
this change and a full scale review of banking laws is being undertaken to identify the nature of legislation
needed. Early action in this area should have high priority.

A key issue in banking reforms in the future relates to government control over public sector banks. Public
sector ownership imposes several constraints including limitations in methods of recruitment and
promotion and restrictions on the salaries they can pay. Public sector banks are also burdened by
standards of public accountability which may be inconsistent with the degree of flexibility needed for
commercial decision making. Many credit decisions taken in good faith can end up as non-performing
assets for a number of reasons but public sector managers are peculiarly vulnerable to accusations that
such decisions were mala fide ab initio and these accusations can often trigger lengthy investigations by
investigative agencies and also become issues of public concern. This can lead to an overly cautious
approach on the part of bank managers impairing the speed and quality of decision making. The
Committee on Banking Sector Reforms has recommended that the government’s equity holding should
be reduced to 33% which would free the banks of constraints arising from government ownership.. No
decision on this issue has been announced thus far. The weight of international experience is certainly in
favour of moving away from government ownership, though a consensus on this issue is yet to develop in
India.

ii] Capital Market Reforms

8Parallel with reforms in banking iMajor changes have taken place in the capital market in the past seven
years. In 1991 India’s capital market did not have a statutory regulatory framework. The Securities and
Exchange Board of India (SEBI), was given statutory powers in 1992 and has since laid down a structure
of regulations governing various participants in the capital markets, including rules for insider trading,
take-overs, management of mutual funds, etc. These rules are now in operation and will need to be
refined on the basis of experience. The stock exchanges, which were earlier dominated by brokers and
lacked effective supervision, are now much better governed. The focus of the new regulations is to
ensure investor protection through transparency and full disclosure.

9Important changes have taken place The technology of trading has been modernised. The National
Stock Exchange introduced on-line electronic trading in 1994 and the system today allows brokers
located in 140 cities and towns all over the country to trade in a single unified market through terminals
linked by VSAT to the NSE computers. It provides automatic matching of buy and sell orders with price
time priority, ensures transparency for investors and assurance of the best price. Competitive pressure
has led the Bombay Stock Exchange also to introduce an on-line trading system in 1995, with linkages to
brokers all over the country.

Prior to 1996, India’s capital market was burdened by the fact The settlement system has also seen major
improvement. Earlier, that completion of a trade involved physical transfer of share certificates from the
seller to buyer followed by submission of the certificates to company registrars to effect changes in the
register of stock holders. The process was vitiated by long delays, frequent loss of certificates, return of
certificates because signatures of the seller on the certificates did not match with signatures on record
with registrars, and also the danger of forged certificates. In 1996, a National Depository commenced
operations offering investors the facility of holding securities in dematerialised form and settling trades
through book entries in the depository, eliminating delays and uncertainties in transfer of ownership. The
volume of business done by the Depository has expanded rapidly. In June 1997 only 48 companies with a
market capitalisation of Rs.94,000 crores had signed up enabling their securities to be dematerialised. By
June 1998 this had increased to 198 companies with a market capitalisation of Rs.2,88,000 crores. The
value of securities actually dematerialised increased from Rs.2518 crores to Rs.35,000 crores in this
twelve month period.

These changes are slowly putting in place a set of capital market institutions which can generate
confidence among investors and encourage financial intermediation in this area. As with all institutional
development, much depends upon how the system actually functions under the new rules and regulations
but a good start has been made. The presence of FIIs, which have invested a total of around US $9
billion in the stock markets, is an important force which will push capital market to come closer to
international standards.

iii] Insurance Sector Reforms

82 The missing element in India’s financial sector reform thus far relates to insurance which remains
industry by law a a public sector monopoly, a situation which exists in only three other countries, Cuba,
North Korea and Myanmar. The industry suffers from a very high mandatory requirement for investment
of the life fund in government securities which lowers the implicit return on insurance products. The lack
of effective competition also leads to a lack of variety in pension products available for savers. 3Reform of
the Opening the insurance sector by opening it up to new private sector participants, with suitable
regulation is clearly overdue. It will help consumers by providing a vigorous and create a more
competitive insurance industry, offering attractive insurance and pension products, which become
especially important as per capita incomes rise, life expectancy increases and traditional family support
systems, which are a substitute for insurance and pensions, are eroded. A vigorous insurance industry
would also increase the volume of long term contractual savings in the economy and channelise these
savings towards infrastructure sectors which have the greatest need for long term funds.

The pace of insurance reform in India reflects both the time taken to build a consensus on difficult issues
and also the fact that a consensus does evolve. The Congress government had recognised the
importance of reform in this area and appointed the Malhotra Committee to look into these issues. The
Committee submitted its report in January 1994 and recommended opening up the insurance sector to
private competition permitting foreign investment with a minority stake. No decision could be taken on this
recommendation within the remaining term of the government because of opposition from the Unions.
The United Front government in 1997 moved a step forward and announced its intention of creating a
statutory regulatory authority for insurance and also allowing a limited opening of the the sector should be
opened up pension and health insurance segment to private sector participants to begin with. The
legislation could not be passed because the BJP at that time opposed foreign investment in insurance.
Insurance sector reforms are an unsaturated part of financial sector reforms which should be high on the
agenda for the future In 1998 the BJP Government announced that it will open up all sectors of insurance
for Indian companies, but the extent of foreign investment to be allowed in these companies is yet to be
decided. The Finance Ministry has proposed that foreign investors (insurance companies) may be
allowed upto 26% of equity, with additional scope for investment by NRIs taking the combined total of
foreign equity to 40%. A final decision on this proposal has yet to be taken. The area of consensus on
insurance has clearly widened considerably over the years but it has taken a long time. It is worth noting
that even if the Finance Ministry’s proposal is approved, legislation will have to be introduced in
Parliament to give effect to the decision and the earliest this process could be completed will be
sometime in 1999. This will be more then five years after the Malhotra Committee submitted its report !

i] Policies for Poverty Alleviation

The impact of the reforms on the poor has been a constant focus of the policy debate in India. Supporters
claim that the reforms will help the poor by encouraging rapid and efficient growth, which in India’s
circumstances means labour using employment generating growth, and this is the only sustainable way of
reducing poverty to any significant effect. Critics claim that this process will take time especially if reforms
are implemented at a gradualist pace and large sections of the population may therefore not benefit in the
early stages. Some sections may even be hurt as certain kinds of products and processes are displaced
by structural changes brought about by the reforms. India’s reform programme sought to deal with these
problems by combining structural reforms with strong poverty alleviation programmes to ensure an
adequate flow of benefits to the poor even in the short term.

From the outset, the reforms emphasised a continuing commitment to the traditional programmes for
poverty alleviation which existed even before the reforms. These included direct support of consumption
of the poor by subsidised sale of foodgrains through the Public Distribution System, employment
programmes providing wage employment in public works type projects especially in rural areas and a
variety of self-employment programmes involving provision of a combination of capital subsidy, credits
and technical assistance to set up micro-enterprises in both rural and urban areas. Fiscal constraints in
the first two years of the reforms prevented any large increases in these programmes but there was a
substantial expansion from 1993-94 onwards.

The effectiveness of these programmes in achieving their stated objective varies considerably. Parikh
(1997) has shown that the public distribution system is a very inefficient instrument for helping the poor
since the entitlement of subsidised supply is available equally to all households and in practice the poor
have less access to the system. The spread of the PDS varies considerably across the country and most
of the offtake is accounted for by a few States where the PDS is well organised and these are not the
States where poverty is most concentrated. In 1997 the United Front government tried to introduce better
targeting in the system by distinguishing household below the poverty line which would obtain their
entitlement at a lower price, but it is too early to judge how effectively this is being implemented. The
other poverty alleviation programmes are better targeted, especially those providing wage employment,
and it is generally agreed that they have helped to provide income support to lower income groups. The
experience with self-employment programme is much more varied. While reasonably well targeted it is
not clear that they provide a sufficiently stable additional flow of income to the beneficiaries.

As the reforms progressed the approach to poverty alleviation was broadened to include efforts to
improve the supply of social services especially health education and family welfare. This focus was
spurred by the recognition that India lags far behind most other developing countries in this respect
including most countries in sub-Saharan Africa which are otherwise regarded as least developed. As
pointed out by Dreze and Sen (1995) India’s social development indicators at the start of the reforms
were lower then in the East Asian countries three decades ago which suggest that unless significant
improvement take place in these indicators, it may not be possible to achieve growth rate of 7 to 8 % as
envisaged by the reforms. Larger investment in the social sectors is regarded as necessary not only
because social development is an end in itself, but also as a precondition for accelerating growth.

Trends in the Central government social services expenditures as a percentage of GDP in the post-
reform years are summarised in Table 10. These show a marginal decline in the first two years of the
reforms, when the fiscal situation was under severe pressure, followed by a steady increase after 1993-
94. However, the real problem in this area relates to expenditure in the States which account for the bulk
of social services expenditure. As shown by Guhan (1995) social service expenditures at the State level
as a percentage of GDP declined steadily in the post reform years up to 1994-95 and this decline
swamps the increase in Central government expenditure so that the trend in consolidated expenditures
shows a steady decline.

The poor state of social indicators in India is obviously not a consequence of the reforms but a reflection
of prolonged neglect of this crucial area in the pre-reform years. However the trend of the past few years
is clearly alarming and has to be reversed. Remedial action lies primarily in the domain of the States and
this underscores the importance of fiscal reform and restructuring at the States level. In practice this
means that States must take hard decisions to electricity tariffs to reduce the large losses of the State
Electricity Boards, increase water charges to reduce the very large operating deficits of the irrigation
system and also reduce losses of the State Road Transport Corporations. These corrections would ease
demands on State Government budgets from these sectors enabling the States to expand social sector
expenditures. A major effort in this area, combined with continuing reforms is probably much more
important for poverty reduction than marginal expansions in the traditional poverty alleviation schemes
even though these are often seen to respond more directly to the demand for tackling poverty. In fact, the
present levels of leakages from these programmes are so high that major improvement is needed in
administrative arrangements, including involvement of NGOs, to improve the effectiveness of these
programmes before attempting any significant expansion on their scale.

34. Conclusions

4 India’s achievements in the past seven years as far as economic performance is concerned are clearly
impressive. The recovery from the 1991 crisis was exceptionally swift and the post stabilisation period
saw a significant acceleration in growth compared with the growth rate before the reforms. The rate of
growth in the four years 1994-95 to 1997-98 averages 6.9 %. This amounts to growth in per capita GDP
of over 5 percent per year. Poverty may have increased in the first two years after the crisis, but this was
not because of the reforms and in any case, the deterioration was reversed by 1993-94. It is likely that
Thereas economic growth accelerated in subsequent years, the incidence of poverty also resumed its
earlier declining trend.

The good performance thus far does not mean however that high growth rates will be easy to maintain,
let alone accelerate, in future. The slowdown in 1997-98 and the continuing crisis in East and South East
Asia raise legitimate concerns about the pace at which India can grow in the near future. The Asian crisis
has proved to be deeper and is likely to be more prolonged than was initially expected and its depressive
effect on world growth and on India is likely to continue in 1998-99. The imposition of sanctions by some
countries following the nuclear tests by India and Pakistan in May 1998 has added new uncertainties, the
scope and duration of which is not yet clear. However, even if we assume that the sanctions are
temporary or their effect is marginal, it is clear that the international environment facing in India in the next
two years will be less supportive than in the recent past. World trade is likely to grow more slowly,
competition from South East Asia will intensify, and the environment for capital flows to emerging market
is likely to be more restrained. All this suggests that India will have to make additional efforts to ensure
that the post reforms growth rate is maintained.

The reforms underway are clearly wide ranging and have yielded good results thus far, but they need to
be further strengthened. A credible signal that reforms will continue and a clearer statement on the time
path of reforms will increase confidence among investors both domestic and foreign. The fact that three
different governments have endorsed the broad direction of reforms indicates that while there may be
differences in emphasis and even more so in presentation, there is also a substantial consensus on many
of these issues. This should help to insulate economic policy from perceptions of political uncertainty
which are perhaps unavoidable in an era of coalition politics.

Where reforms have already begun they should be swiftly completed preferably with a clearly announced
time frame. Examples of such continuing reforms are the reduction in protection levels, continuing reforms
in banking, decontrol of petroleum prices, reform of the power sector etc. An important positive factor for
the future is that the productivity gains from many of these ongoing reforms have yet to be realised. For
example, the new investments made responding to the

more open environment gained momentum only in 1995-96, when corporate investment and foreign
investment picked up (Tables 4 and 8) and the benefits from these investment will materialise only in the
years ahead. Similarly, reforms in the public sector and in the financial system are as yet at an early
stage, and the improved allocational efficiency from these reforms are only just beginning to be realised
and should provide significant efficiency gains for the economy in the future.

There are also many areas where reforms have not yet gained momentum and these will now have to be
addressed with urgency. An obvious area for priority attention is the continuing high level of the fiscal
deficit of the Centre and States combined. Unless this deficit is reduced significantly, the economy will not
be able to transit to a regime of low real interest rates which, with efficient financial intermediation, can
give a boost to private investment. This calls for a two pronged approach. It will be necessary to
restructure of Government expenditure by restraining inessential expenditure while increasing
government expenditure in important areas. It also calls for further tax reform, especially in excise duties,
and a strengthening of the tax administration to increase buoyancy in tax revenues. These efforts can be
supplemented by much bolder efforts at privatisation of the public sector generating larger revenues from
privatisation. There is much greater acceptability of privatisation today than was the case even two years
ago and this new consensus should be used to strengthen policies in these areas.

Infrastructure bottlenecks are likely to be a binding constraint on even achieving 7% growth over the next
few years. India’s infrastructure system is clearly overstrained and has suffered from under investment in
the post reforms period. Massive investments will be needed in both the public and the private sector to
overcome this bottleneck. The two are not alternatives because the need is so great that even the most
optimistic projection for private investment will leave a large proportion of the need to be met by the public
sector. Public investment in infrastructure depends crucially upon the ability to raise resources in the
public sector and this in turn depends upon the ability to levy user charges. Reform of power sector tariffs,
introduction of road user charges (either direct in the form of tolls or indirect in the form of a cess on petrol
and diesel earmarked for road development) and rationalisation of railway fares are all extremely
important in this context.

These efforts at expanding public investment in infrastructure must be supplemented by a vigorous effort
to attract private investment by creating an environment which is attractive to private investors. This
includes simplification and transparency of various clearance procedures, a policy framework which
allows the various risks involved in infrastructure projects to be unbundled so that private investors are
expected to take only lthose risks which it is reasonable for them to bear, and a credible and independent
regulatory framework which assures private investors of fair treatment. Fortunately a number of private
sector infrastructure projects in power, telecommunications and ports have taken off and the process
could gain momentum.

The pace of private investment in infrastructure will of course depend upon the availability of finance for
such projects especially debt finance. There are limits to the amount of foreign currency exposure which
infrastructure projects can take since the tariff in most cases is fixed in local currency and this limits the
extent of foreign exchange risk which the project can take. Infrastructure development in the private
sector will therefore depend crucially upon the availability of long term debt finance for such projects at
reasonable interest rates. This will depend partly upon macro-economic developments, especially the
ability to reduce the fiscal deficit, and partly on the pace of financial sector reform especially insurance.
Early implementation of reforms in insurance will clearly help to stimulate private financing of
infrastructure.

Finally, India cannot afford to ignore the poor state of social indicators relating to health and education
which has resulted from prolonged neglect of the important area over the decades. Other countries,
starting from a similar situation have been able to improve the level of social development over time
through determined public action. Some States in India have also done so; Kerala is the best known
example but more recently Tamil Nadu has made excellent progress in literacy and fertility and Himachal
Pradesh has also shown significant improvement in literacy and primary schooling. This is clearly an area
where the public sector must play a dominant role. Indeed, the role of the State needs to be redefined to
withdraw from direct involvement in areas which can be easily privatised and to expand in areas such as
the social sectors where the State is the natural, and in most cases, the only agent.

To summarise, the process begun in 1991 has proceeded steadily if not as rapidly as its should have but
the changes already made and those currently underway are impressive. At the same time there are
formidable challenges ahead many of which will involve forays into more difficult areas than has been
necessary hitherto. It is essential to make steady progress in addressing these new challenges if India is
to achieve the objective of 7 to 8% growth.

* The author is currently serving as Member of the Planning Commission, Government of India. The views
expressed in this paper do not necessarily reflect the views of the Commission. Thanks are due to Isher
Ahluwalia, Surjit Bhalla, Nirvikar Singh and T.N. Srinivasan for helpful comments on an earlier draft.

References

Guhan. S, "Social Expenditure in the Union Budget, 1991-96" Economic and Political Weekly May 6-13,
1995

Yergin. Daniel, "The Commanding Heights" Simon and Schuster 1998

Ahluwalia Montek S, "Infrastructure Development in India’s Reforms" in "India’s Economic Reforms and
Development Essays for Manmohan Singh" edited by Isher J. Ahluwalia at IMD Little (eds) Oxford
University Press, Delhi 1998

Ahluwalia, Montek S, "Financing Private Infrastructure: Lessons from India" in Choices for Efficient
Private Provision of Infrastructure in East Asia, Harinder S. Kohli, Ashoka Mody and Michael Walton (eds)
The World Bank Washington DC 1997

Parikh, Kirit. "Who gets how much from PDS; How effectively does it reach the poor" Sarvekshana Vol 17,
No.3, 1994.

Tendulkar, S. "Indian Economic Policy Reform and Poverty; An assessment" in "India's Economic
Reforms and Development Essays for Manmohan Singh" edited by Isher J Ahluwalia and IMD Little (eds)
OUP 1997

Dreze Jean and Amartya Sen." India : Economic Development and Social Opportunity" Oxford University
Press, Delhi 1995.

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Articles
Sh. Montek S. Ahluwalia Deputy Chairman, Planning Commission

PLANNING COMMISSION, GOVERNMENT OF INDIA, YOJANA BHAWAN, SANSAD MARG

NEW DELHI - 110001. Copyright @2013