5 Trade Policy Reforms: The Indian Experience
- Naheed Kirmani, and Chorng-Huey Wong
- Published Date:
- April 1997
India embarked on a comprehensive economic reform program in mid-1991. The external trade sector became the focus for substantive liberalization from the very beginning of the reform process. As a result, substantial progress has been achieved in this sector during the last three and a half years. This paper, which appraises this period, is divided into three sections. The first provides the background against which the reforms were initiated. The second deals with the major policy initiatives and an appraisal of their impact. The third is devoted to the issues and policy dilemmas faced in designing and implementing the trade policy reform package.
Brief Evaluation of the Prereform Strategies
For over forty years in the postindependence period India pursued a strategy of economic development oriented toward import substitution and self-reliance. Strongly influenced by the socialist ideology, the Industrial Policy Resolution adopted in the early 1950s stipulated that the commanding heights of the economy should be under public ownership and control. Major sectors of manufacturing, such as steel, heavy-engineering facilities, earthmoving equipment, process plants, aircraft, ships, telecommunications and power facilities, basic chemicals and smelting of nonferrous ores, were reserved for the public sector. Even in areas open to the private sector, the establishment of new production capacities was tightly controlled through an elaborate system of industrial licensing covering medium and large undertakings and a system of registration covering small units. Before such capacities were allowed to be created, an overall demand-supply assessment was undertaken within the framework of a centralized planning apparatus. In sectors where a clear supply gap had emerged, there was often a race among competing private entrepreneurs to secure the required industrial-licensing approval. Obtaining a license itself was perceived as a major achievement. At times, with a view to preventing others from entering the same field of production, an existing manufacturer would sponsor another party to get some capacity allocated, not with the intention of implementing the project but for blocking another person from doing so. As a result, several quasi-monopolies were created, wherein concerns about quality, productivity, cost control, and efficiency were relegated to lower levels of priority. In some cases, the desire to allocate the available incremental production capacity among a larger number of applicants would result in the licensing of suboptimal-sized units that could not, ipso facto, enjoy the economies of scale.
Securing a letter of intent for establishing a new manufacturing unit was, however, only the beginning of a series of other approvals that had to be laboriously pursued by the entrepreneur. Proposals for importing technology or foreign investment had to go before an Inter-ministerial Foreign Investment Board. Questions regarding reasonableness of technical license fees, royalties, and other forms of capital repatriation had to be answered. Applications for the import of capital goods and other raw materials and components had to go before a separate Licensing Committee in the Office of the Chief Controller of Imports and Exports (CCIE). While considering such applications, the CCIE would seek the technical opinion of the Directorate General of Technical Development (DGTD) as to whether the items proposed could not be sourced from within the country itself. Besides, in the case of capital goods and instruments, a trade notice had to be published in the Indian Trade Journal by the party seeking the import permission, and a period of 45 days had to be given to indigenous suppliers who might wish to offer their equipment to meet the entrepreneur’s needs. The entrepreneur had also to engage in technical discussion with the DGTD officials to convince the latter that the item sought to be imported had special technical features that could not be matched by domestically produced substitutes, if any.
Yet another factor to be considered at the time of granting an industrial license was whether the entrepreneur either belonged to a “monopoly house” or was already enjoying a monopoly position in the domestic market, such terms being defined in the “Monopolies and Restrictive Trade Practices Act.” If a market leader wanted to expand its production base, permission could be refused on the grounds that creation of a near monopoly would amount to an excessive concentration of economic power, which had to be prevented. Such refusals forced some Indian companies to venture overseas and, unintentionally, started the process of “globalization,” involving the setting up of overseas production bases by them.
Once the Indian entrepreneur had surmounted hurdles of industrial licensing, import licensing, and rigorous foreign exchange controls, it had the opportunity to function under conditions of relatively low competitive pressure from within and little fear of competition from imports, keeping in view the existence of both quantitative restrictions on import (QRs) as well as high levels of import tariff, which in some cases could be as high as 300 percent. Naturally, as mentioned earlier, considerations of design, quality, cost efficiency, and productivity were at a discount within the production and distribution system.
Since the macroeconomic policy regime created an economy that was expensive and often inefficient, export promotion was sought to be achieved through microlevel strategies. This obviously meant identifying products that, according to the government’s perception, should be promoted and designing a mix of incentives geared to that objective. The incentive mix, broadly consisted of fiscal incentives, incentives through import policy, and concessional export finance.
When reforms were launched in July 1991, the first two sectors that received attention were those of industrial licensing and import policy. In the case of industrial licensing, formal licensing requirements were given up for all industries except some that were retained on the licensing list for special considerations of sensitivity and environmental safety. In the case of import controls, the policy decision was taken that the import of all production inputs, as distinct from finished consumer goods, should be liberalized. Capital goods, intermediates, components, and industrial raw materials were almost entirely thrown open for import at the option of the manufacturer himself or by the trade, for stock and sale. The underlying logic was that if the Indian industry was to come of age and build up competitive production capability, it should be allowed access to the best capital equipment, instrumentation, and raw materials and components without having to knock on the doors of the import-licensing authorities. The broad area of consumer goods was, however, restricted on balance of payments considerations under Article XVIII of the General Agreement on Tariffs and Trade (GATT). The elaborate listing of items in different lists such as “Banned,” “Negative,” “Limited Permissible,” and “Canalized” was pruned drastically.
During the period of elaborate import controls, exporters used to be permitted to obtain some inputs related to their export products under a system of “Replenishment Licenses.” Over 100 pages in the Import-Export Policy Book used to be devoted to the listing of various export products along with associated “shopping lists” of items that could be imported under the replenishment license granted to exporters. Lifting import controls on production inputs in the second half of 1991 made the system of replenishment licenses redundant.
As regards dismantling of the high import-tariff regime, in the first budget of the present government in July 1991, the peak import tariff rate was brought down from over 300 percent to 150 percent. In the regular budget for fiscal year 1992/93 presented in February 1992, the peak rate was reduced to 110 percent and in the subsequent budget of 1993/94 presented in February 1993, it was reduced to 85 percent. In the budget for fiscal year 1994/95 presented in February 1994, the peak rate was further brought down to 65 percent. The average tariff collection rate for all imports that stood at 47 percent in 1990/91 came down to 44 percent in 1992/93, 37 percent in 1993/94, and 30 percent in 1994/95. An Expert Committee on Tariff Rationalization appointed by the government has recently suggested that the peak tariff rate be lowered further to about 25 percent within the next two years or so. As a result of the steep drop in the level of tariff protection, India has more than met its tariff reduction commitments in the context of the Uruguay Round of Multilateral Trade Negotiations much in advance of the six-year transition period provided for achieving the targeted tariff reduction. In some items, which may still be attracting higher import tariffs, the necessary reduction would be made well within the permissible period.
Even before the reform process was initiated, it was clear to many observers that the export-incentive system as had been practiced was no longer feasible because of the fiscal burden it had been causing. Export subsidy for the Cash Compensatory Support in conjunction with the food and fertilizer subsidy had accounted for a substantial portion of the total budget deficits of the Government of India.
Since the total incidence of all export incentives was estimated to be around 20 percent, it could be argued that devaluing the external value of the rupee by the same order of magnitude would maintain the export price competitiveness at the same level. In addition, since the reform process also involved a paradigm shift from an administrative microlevel policy regime to a generalized market driven policy frame, the importance of the exchange rate as a determinant of trade flows would have to increase in the postreform period.
Practical feasibility of using the exchange rate as a determinant of trade flows depended upon to what extent the rupee, which was a nonconvertible currency and whose external value was strictly monitored, could be allowed to find its own level and whether and in what time frame convertibility could be introduced. It was clear in the beginning that trade policy reforms would have to look at the totality of the policy package, namely, quantitative and administrative controls on imports and exports, the tariff structure, and controls on foreign exchange, in addition to the initial devaluation of the rupee to take care of the existing overvaluation and allowing it to float within the market parameters. The government adopted an incremental approach with respect to all these issues. First, the rupee was devalued in two stages: on July 1, and on July 3, 1991, by about 18–20 percent against major currencies. Immediately after the devaluation, trade policy changes were introduced. One major change was the abolition of the Cash Compensatory Support and introduction of partial convertibility of the rupee.
Prior to reforms, all foreign exchange earnings were to be compulsorily surrendered to the Reserve Bank of India. What was allowed in the initial phase of liberalization was that exporters would have to surrender 40 percent to the Reserve Bank at the official rate while the residual 60 percent could be sold at the market-determined rate. Although many feared that the rupee would crash in the market-determined segment, it showed remarkable strength after an initial dip. This emboldened the government to proceed toward “full convertibility” on the trade account. The logic was twofold: first, the dual rate was in fact a tax on exports, as exporters would have to sell 40 percent of their foreign exchange earnings at the official rate, which was 10–15 percent lower than the market rate. Second, full convertibility on the trade account would be the next step forward in deregulating the external sector of the Indian economy. Accordingly, the rupee’s dual exchange rate system was abolished and a unified exchange rate system was introduced in the budget for 1993/94. Since then, the rupee has remained stable against major currencies.
In order to give a fillip to export production, the system of issue of advance duty-free licenses to facilitate such production using imported inputs of raw materials and intermediates has been strengthened. In addition, the Export Promotion Capital Goods Scheme was introduced to reduce the capital cost by allowing the import of capital goods at a concessional duty of 15 percent, subject to the assumption of some export obligations.
Prior to the launching of reforms, the negative list of exports consisted of five categories, namely, prohibited list, licensable list, ceiling list, canalized list, and the conditional list. The number of items under these heads has now been reduced to less than fifty under three heads: prohibited list, licensable list, and the canalized list. Export controls have been lifted from nearly 90 percent of the items that had been restricted. Simplifying trade documentation and introducing electronic trading concepts have also been receiving sustained attention.
Evaluation Framework and Record
The achievements of the reforms process vis-à-vis the trade regime can be evaluated prima facie by considering (1) to what extent quantitative controls on India’s imports have been reduced; (2) what level of import tariff reduction has been achieved; and (3) to what extent policy stability and transparency in the system have been introduced.
The record with respect to the first has been fairly impressive. Using the proportion of imports subject to licensing, it is found that the proportion has declined from 52.6 percent in 1989–90 to only 33.8 percent in 1992–93 and to 30.2 percent in 1993–94. There has also been a corresponding decline in the number of import licenses issued. While during 1989–90,116,094 import licenses were issued, the number dropped to only 41,000 during 1993–94. Further, to the extent of almost 95 percent, these licenses have been issued for duty-free or concessional duty imports having export linkages.
As mentioned earlier, the only substantial remaining area of import controls covers the sector of consumer goods. Even in this regard, significant import liberalization has recently been permitted through the Special Import License route, which is granted to Export Houses and Trading Houses, and so on, by way of an indirect incentive. Practically all textile items in addition to several consumer durables can be imported against such licenses.
The liberalized export-import policies will have maximum impact only when two conditions are satisfied: first, that there has to be long-term stability in the policy and, second, that there should be transparency, including procedural simplicity. To achieve the first condition, a five-year Export-Import Policy was announced for the period 1992–97. As regards procedural simplification, the ongoing efforts that have yielded positive results have to be assiduously maintained for some years to come.
The impact of the trade policy reforms on exports appears to be substantial. The first year of the postreform period could achieve an export growth rate of only 3.8 percent in nominal dollar terms, which was conditioned by several adverse factors, including the steep fall in India’s exports under the Rupee Payment Arrangements to the former Soviet Union. In the second year, 1993–94, the rate of export growth substantially increased to over 20 percent in nominal U.S. dollar terms. The rate exceeded what even the major Southeast Asian countries could achieve. While it is true that a part of this growth was due to the low base, as well as the availability of exportable surplus of several items due to sluggish domestic demand, there is no doubt that this definitely represented a break from the trend rate of growth. The rate of growth in exports in the current fiscal year during April 1994–January 1995 has been a little over 17 percent in dollar terms.
Specific Issues in Designing and Implementing Trade Policies
The Indian experience reveals that while designing and implementing trade policy reforms it was crucial to design collateral policies pertaining to tariffs and exchange rates, to restructure the institutional mechanism related to the administration of export-import policies, and to put in place an antidumping machinery to prevent disruption of domestic production due to dumped imports under the lower tariff regime. It became necessary to devise measures to accelerate export growth in the absence of sector-specific strategy and assistance, decide on the pace of removal of QRs and the optimal timeframe for opening up the previously protected industrial sector, bring about attitudinal change in the bureaucracy at the cutting edge, and effectively communicate the logic, rationale, and irreversibility of the trade reforms to domestic trade and industry.
It is not that all these issues cropped up simultaneously or even transparently. Often the issues and concerns surfaced as reactions to specific policy initiatives. For instance, the reduction in import duties on capital goods and removal of quantitative restrictions generated a reaction from the concerned domestic sector. Consequently, to create a “level playing field,” a concessional duty on imports of inputs and reduction in the level of ex-factory excise duty was made.
While implementing the reforms to liberalize trade, a large number of import-licensing lists were abolished in April 1992. With the large-scale decanalization of imports and exports necessitated by freeing of trade, there was a need to restructure the existing institutional framework for trade; for instance, the Office of Chief Controller of Imports and Exports had to be restructured as the Office of the Director General of Foreign Trade with a focus on trade-promotion activities. The traditional role of state trading organizations, such as the State Trading Corporation (STC) and the Minerals and Metals Trading Corporation (MMTC), was curtailed due to decanalization and had to be reoriented with a greater thrust on export promotion. Competitiveness became the crucial factor in deciding on the success and profitability of these state trading agencies, and export activity became more relevant than imports. The focus also shifted from canalized to noncanalized items of trade besides requiring organizational restructuring. To make a trim and efficient structure, a Voluntary Retirement Scheme (VRS) was introduced to reduce the staff by approximately 25 percent. A study was undertaken to work out the organizational restructuring of the state trading organizations with a view to simplifying and making transparent their role and working methods.
With the increased potential for agro-exports in the post-Uruguay period, special measures had to be designed in trade policy to give an advantage to agricultural exports. A new scheme for encouraging export-oriented units (EOUs) for agricultural products had to be introduced with a limited export obligation of 50 percent. Similarly, in an effort to give special support to services exports, a new scheme for encouraging service exports and permitting them the import of capital goods at concessional duty was introduced in the Export-Import Policy update in 1994.
With the liberalization of the import regime and acceleration of export efforts, the volume and rate of growth in the external sector has brought into focus physical infrastructure constraints relating to power, transport, and communications. Constraints on government budgetary resources and the compulsion to reduce public expenditure to reduce the fiscal deficit have necessitated the entry of private capital for infrastructure development. Policy changes have been put in place to privatize the setting up of export-processing zones, container freight stations, inland container depots, and air cargo complexes through a system of approvals by an Interministerial Committee. In addition, power and telecommunications sectors have also been thrown open to private capital as an enabling mechanism for fostering infrastructure development.
The policy change permitting the waiver of compulsory export inspection by the official statutory Export Inspection Agency (EIA) and the option to have an independent inspection arrangement as settled between the buyer and seller has reduced the role and revenue of the agency. With its role rendered partially redundant, special measures were required to redefine the role of the EIA. A supplementary role will hereafter be given to EIA, such as inspection, to ensure adherence to special quality requirements as per the health and safety standards of the importing country, such as in the case of marine products and for the investigation of specific quality complaints received from buyers. The role of EIA is being redefined accordingly and a special Voluntary Retirement Scheme has been introduced to handle the staff redundancy resulting from a reduced role for the EIA.
Given the federal structure of the country and the allocation of the subjects between the center and the states, special issues have been encountered in encouraging participation by the state governments in the national export effort. With subjects like agriculture and land reform falling directly within the purview of state governments, special schemes have been devised toward the strategic removal of bottlenecks in the states. As land reform is a state rather than a union subject, efforts to increase the area under production of tea, spices, and cashew for export have implications involving land legislation at the state level.
The prevailing indirect tax structure with Octroi, sales tax, and other state levies tend to reduce the competitiveness of exports owing to the incidence of multiple taxation. Withdrawal of state levies would reduce the revenues of the state governments and restrict their capital resources for development. Hence, to ensure requisite support for the export sector, special compensation schemes will have to be devised to ensure that export performance is not negatively affected owing to the incidence of nonrebatable local taxes.
Elimination of subsidies as an instrument of trade reforms required abolition of budget support interest subsidy on export credit. The financing cost of high-interest export credit in India vis-à-vis the lower interest costs of competitor countries have obviously affected the cost competitiveness of Indian exports. New schemes for providing export finance at internationally comparable interest rates have had to be designed. Nonsubsidy schemes were introduced to permit rediscounting of export bills and to provide dollar-denominated postshipment and preshipment credit, thus reducing the incidence of interest rate differential on export costs.
The unfinished agenda of trade policy reforms in India will have to address such questions as completing the shift from QRs to a tariff-based regime and providing greater market access in services and financial sectors. The negative list of imports and exports would have to be limited to items that need to be restricted for reasons of environment and safety. In the post-Uruguay period, access to markets, especially in the area of financial services, will also need to be expanded. As the economy becomes more stable and as the external environment improves it would be possible to achieve full convertibility on the capital account as well. Likewise, regional and multilateral trade issues having a bearing on India’s global trade performance will need to be addressed. The impact of regional groupings like the European Union, North American Free Trade Agreement, Asia-Pacific Economic Cooperation Council, Association of South East Asian Nations, and so forth, on multilateral arrangements in the context of the rule-based World Trade Organization with special reference to market access for India’s export products will need to be evaluated to position India effectively in the global trading environment. New issues arising from environmental concerns relating to trade and the question of the linkage between trade and labor standards will have to be appropriately addressed.