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India: are the skeptics right?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 2003
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Take a closer look at the evolution of growth and reforms in India, and three facts stand out that contrast sharply with the DeLong-Rodrik position. First, growth during the 1980s took place in the context of significant reforms. While the reforms were ad hoc and implemented quietly (“reforms by stealth” is the term often used to describe them), they made inroads into virtually all areas of industry and laid the basis for the more extensive July 1991 reforms. Second, growth in the 1980s was fragile and varied significantly depending on the subperiod chosen. This growth was also unsustainable, as it was partially driven by external and internal borrowing. Finally, the more systematic and systemic reforms of the 1990s produced decidedly more stable and sustainable growth from 1992 on.

And, in contrast to the Stiglitz view, India’s reforms have been very much in line with the policies that mainstream economists and the IMF have traditionally advocated. True, the pace of India’s reforms has been slower than what even many pro-reform economists who favor gradualism over shock therapy advocate, but this is to be attributed not so much to conscious choice as to the intricate demands of the country’s democratic political process. In one area—capital account convertibility—India has deliberately chosen to go slowly, but this delay is hardly inconsistent with its embrace of promarket and proglobalization policies in other areas. Indeed, many proglobalization and proreform economists, including the author of this piece, have explicitly advocated such a delay.

Fragile growth in the 1980s

For the three decades from 1951 to 1981, India’s average annual growth rate was a steady, unremarkable 3.6 percent that was often termed the “Hindu rate of growth” (see table). India hit the 5 percent mark for the first time during the 1980s and continued to grow at this rate into the 1990s. What happened in those two decades?

If you compare the two, the first thing that is clear is that the 1980s growth rate is far more variable within the period. For instance, the average growth rate for 1978/79–1987/88 was an unimpressive 4.1 percent. Anyone looking back at this performance would conclude that the economy was still on the Hindu growth path. Even the average growth rate during 1981/82–1987/88 was 4.8 percent—below the rate achieved under India’s Fifth Five-Year Plan (1974—79). Only when the period 1988-91 is included—with its ultra-high growth rate of 7.6 percent—does the average growth rate for the decade jump to 5.6 percent. Without these three years, there would be no debate on the 1980s versus the 1990s growth rate.

Growth during the 1990s was clearly more robust and far less volatile. Major reforms were put in place after India experienced an economic crisis in June 1991. The annual growth rate quickly picked up and reached 5.1 percent in 1992–93 and never fell below 4.3 percent subsequently. And, whereas the growth spurt of the 1980s culminated in a crisis, growth in the 1990s was sustained, with no hint of crisis concerns in the minds of India watchers. Indeed, the tale of India’s pre- and post-1991 experiences is best told by its annual growth rates (see chart).

Fragile growth in 1980s gives way to robust growth in 1990s

Financial year (April 1-March 31)

Data: Government of India, Ministry of Finance, Economic Survey (various issues).

Reforms in the 1980s

Still, what is one to make of India’s fragile yet significantly higher growth during 1977–91, especially 1988–91? Two broad factors—promarket reforms and fiscal expansion—seem to hold the answer. Some would also want to credit good luck in the form of the discovery of oil and generally good monsoons, but these would not have come to much without the other two factors.

By the mid-1970s, India’s trade regime had become so repressive that imports (other than oil and cereals) had fallen from the already low level of 7 percent of GDP in 1957–58 to 3 percent in 1975–76. More than 800 of the most labor-intensive products were exclusively reserved for production by small-scale units. The remaining products were either subject to industrial licensing or produced solely by public sector units.

Though government regulation of industry began to be relaxed in the early 1970s and trade restrictions started to ease in the late 1970s, the pace of reform picked up significantly only in 1985. Here, reforms on six fronts stand out:

  • A reintroduction, in 1976, of a list of items that could be imported without licenses%. Initially, the list contained 79 items, but this grew, by April 1990, to 1,339 items (more than 20 percent of total imported items). In 1987–88, 30 percent of all imports entered without licenses and, typically, with reduced tariffs.
  • Decline in the monopoly rights of the government for the import of certain items%. Between 1980/81 and 1986/87, the share of government-monopolized imports in total imports declined from 67 percent to 27 percent. Over the same period, monopolized rights for imports other than petroleum, oil, and lubricants declined from 44 percent to 11 percent, significantly expanding the room for imports of machinery and raw materials by entrepreneurs.
  • Introduction or expansion of several export incentives, especially after 1985%. Exporters were given replenishment licenses, which could be freely traded on the market. This directly helped relax the constraints on some imports, notably inputs for goods sold in the domestic market. In addition, between 1985 and 1990, profits on exports where exempt from taxation; the interest rate on export credit was reduced to 9 percent from 12 percent; and duty-free imports of capital goods were allowed in selected “thrust” export industries.
  • Beginning in 1985, a substantial relaxation of industrial controls%. By 1990, 31 industries were completely delicensed (27 remained under licensing); the asset ceiling of firms designated as small-scale industries was raised substantially; broad banding, which allowed firms to switch production between similar product lines, such as trucks and cars, was introduced in 1986 in 28 industry groups and expanded subsequently; also in 1986, firms that had reached 80 percent capacity utilization in any of the five years preceding 1985 were assured authorization to expand capacity to up to 133 percent of the maximum capacity utilization reached in those years; price and distribution controls on cement and aluminum were entirely abolished; and the asset limit on firms subject to the purview of the Monopolies and Restrictive Trade Practices Act was raised fivefold. This allowed firms under the asset limit to take advantage of the new liberalized measures. For firms still covered by the law, clearances were waived for 27 industries altogether, and several constraints were relaxed in other industries.
  • Major reform of the tax system%. Multipoint excise duties were converted into a modified value-added tax, which enabled manufacturers to deduct excise paid on domestically produced inputs and to deduct countervailing duties paid on imported inputs from their excise obligations on output. By 1990, the modified value-added tax covered all subsectors of manufacturing except petroleum products, textiles, and tobacco. This change significantly reduced the taxation of inputs and the associated distortions. In parallel, the authorities introduced a more smoothly graduated schedule of excise tax concessions for small-scale industries, which reduced incentives for them to stay small.
  • And, perhaps most important, India’s adoption of a realistic exchange rate%. The real exchange rate appreciated marginally during 1979-81, stayed more or less unchanged until 1984-85, and then depreciated steadily thereafter. Between 1985/86 and 1989/90, the effective exchange rate depreciated by a hefty 45 percent in nominal terms, and 30 percent in real terms.

These reforms had discernible effects on all areas of the Indian economy. Imports expanded and, with them, the share of imported capital in total investment. The incremental capital-output ratio declined from 6 to 4.5. Industrial growth accelerated from 4.5 percent in 1985/86 to a peak of 10.5 percent in 1989/90. In their 2002 study, researchers Satish Chand and Kunal Sen of the Australian National University found that India had experienced a significant jump in productivity growth in all industrial sectors, and that this had been directly linked to liberalization.

India journeys from “Hindu rate of growth” toward a miracle
PeriodGDPPer capita GDP
1951-613.92.0
1961-713.81.5
1971-813.20.9
1981-915.63.5
1991-015.73.7
Memo
1951-743.61.5
1977-915.12.9
1992-026.14.1
Data: Government of India, Ministry of Finance, Economic Survey (various issues).
Data: Government of India, Ministry of Finance, Economic Survey (various issues).

Unsustainable borrowing and spending

But the steps that India took to liberalize its industrial and trade sectors tell only a part of the 1980s story. The country’s rapid growth before 1991 was also being fueled by borrowing abroad and rising government expenditures at home. During 1985–90, gross domestic saving and investment were, on average, 20.4 percent and 22.7 percent of GDP, respectively. With direct foreign investment negligible and annual foreign aid unchanged at approximately $400 million through much of the 1980s, foreign borrowing largely made up the difference between saving and investment.

While foreign borrowing helped boost investment and imports, it also led to a rapid accumulation of foreign debt, which rose from $20.6 billion in 1980/81 to $64.4 billion in 1989/90. The accumulation was especially rapid during the second half of the 1980s, with long-term borrowing rising from the annual average of $1.9 billion between 1980/81 and 1984–85 to $3.5 billion between 1985/86 and 1989/2000. The ratio of external debt to GDP rose from 17.7 percent in 1984/85 to 24.5 percent in 1989/90. Over the same period, the debt-service payments as a proportion of exports rose from 18 percent to 27 percent.

As the volume of India’s debt grew, the quality of debt deteriorated rapidly between 1984/85 and 1989/90. The share of private borrowers in total long-term debt increased to 41 percent from 28 percent; the share of nonconcessional debt rose to 54 percent from 42 percent; and the average maturity of debt declined to 20 years from 27 years. Indeed, while external debt was helping the economy grow, it was also steadily moving it toward a crash.

Similar developments were occurring on the internal front. Defense spending, interest payments, subsidies, and higher wages stoked public sector spending. During the first half of the 1980s, current expenditures of the combined central and state governments averaged 18.6 percent of GDP. By the second half of the decade, however, these expenditures averaged 23 percent of GDP, with the bulk of the expansion coming from defense, interest payments, and subsidies, whose average rose to 11.2 percent of GDP from 7.9 percent.

Like external borrowing, high current expenditures, which manifested themselves in extremely large fiscal deficits, proved unsustainable. Combined fiscal deficits of the central and state governments, which averaged 8 percent of GDP in the first half of the 1980s, rose to 10.1 percent of GDP in the second half. Large deficits led to a substantial buildup of public debt, with interest payments accounting for a large proportion of government revenues. They also inevitably fed into external current account deficits, which rose steadily to reach 3.5 percent of GDP and 43.8 percent of exports in 1990–91. The eventual outcome of these developments was the June 1991 crisis.

A bright future

What key lessons can be gleaned from this experience? It is that the fragile but higher growth in the 1980s provided firsthand evidence to policymakers that gradual liberalization could deliver faster growth without causing disruptions. It was a lesson that emboldened reformers to move forward with the major steps taken in the July 1991 budget. And it was these more sweeping measures that translated into the more robust and sustainable growth that India has enjoyed since 1992.

Is there still much to do? Of course, but there has been a discernible shift in attitude and confidence. Despite well-known vulnerabilities resulting from large fiscal deficits and the slow pace of banking reforms, few pundits are predicting an external crisis today. India’s ratio of external debt to GDP has been declining, and its foreign exchange reserves, at approximately $90 billion, exceed currency in circulation.

The truth is that despite numerous hiccups, India’s reforms have continued and are likely to continue further. This, together with the likely continuing expansion of the country’s dynamic information technology sector, augurs well for India’s long-term growth prospects.

The longer paper on which this story was based—”India in the 1980s and 1990s: A Triumph of Reforms”—was presented at the IMF-National Council on Applied Economic Research Conference “A Tale of Two Giants: India’s and China’s Experience with Reform and Growth” on November 15–16 in New Delhi. A report on the conference will appear in the next issue of the IMF Survey.

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