India - Recent economic developments and prospects

Report No. 12940-IN India Recent Economic Developments and Prospects May 27, 1994 Country Operations, Industry and Finance Division India Country Department South Asia Region FOR OFFICIAL USE ONLY MICROGRAPHICS Report No: 12940 IN Docunet of the World Bank Type: ECO This document has a restricted distribution and may be used by recipients only in the perfomance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENC Rs/US$ Official Market' Prior tca June, 1966 4.76 June 6, 1966 to mid-Deeber 1971 7.50 Mid-December 1971 to end-June 1972 7.28 1971-72 7.44 1972-73 7.71 1973-74 7.79 197't-75 7.98 1975-76 8.65 1976-77 8.94 1977-78 8.56 1978-79 8.21 1979-80 8.08 1980-81 7.89 1981-82 8.93 1982-83 9.63 1983-84 10.31 1984-85 11.89 1985-86 12.24 1986-87 12.79 1987-88 12.97 1988-89 14.48 1989-90 16.66 1990-91 17.95 1991-92 24.52 1992-93 26.41 30.65 1993-94 31.36 Januaiy 1994 31.37 February 1994 31.37 March 1994 31.37 Surce: IM, Internaional Finial Staistics (IFS), line "rf. ", and Reserve Bank of India. Note: The Irdian fiscal year runs from April 1 through March 31. ' A da exchagc rate system was oed in March 1992, with a free markat for about 60 pee of foreig excage masctiom. The emobange rte ws rmifd at the beging of March 1993 at the free market islew  FOR OFCIAL USE ONLY ABBREVIATION'S AND ACRONYMS BIFBR Board of Indusrrtal and Financial Restructuring BOD Biochemical Oxygen Demand BOT Bulld-Operate-Transfer -CD Ce-tificate of Deposit CMIE Centre for the Monutoring of the Indian Economy CP Comnmercial Paper CPCB Central Poilution Control Board CPI Consumer Price Index CRR Cash Rescrve Requirement DALY Disability-Adjustnent Life Year DHI Department of Heavy Industries DOT Department of Telecommunications EAP Environmental Action Programme ECB Euro-Convertible Bond FERA Foreign Exchange Regulation Act FII Foreign Institutional Investor FIPB Foreign Investment Promotion Board GDR Global Depositorv Receipt GOI Government of India GOM Government of Maaharashtra HC Hydrocarbons HMT Hindustan MIachine Tools HS Harmonized System of classification IRDP Integrated Rurai Development Programme JFM Joint Forest Management JICA Japan International Cooperation Agency JRY Jawahar Rozgar Yahana MINAS Minimum National Standards MKL Mysore Kirloskar Ltd MLR Minimum Lending Rate MODVAT Modified Value-Added Tax hIoEF Ministr; -f Environment and Forests MOU Memorandum of Understanding MW Megawatt NAEB National Agricultural Extension Board NEERI National Enviromnental Engineering Institute NGO Non-Governmental Organization NRF National Renewal Fund NRI Non-Resident Indian NTC National Textile Corporation NTPC National Thermal Power Corporation ODA Official Develpment Assistance ODB Overseas Depository Bank OGL Open General License OSEB Orissa State Electricity Board PA Protected Area PE Public Enterprise RBI Reserve Bank of India REER Real Effective Exchange Rate SBI State Bank of India SEB State Electricity Board SEBI Securities and Exchange Board of India SIA Secretariat of Industrial Approvals SLR Statutory Liquidity Requirements SPCB State Pollution Control Board SPM Suspended Particulate Matter UNEP United Nations Environment Programme WHO World Health Organization WPI Wholesale Price Index This document has a resticted distimbution and may be used by recpients only in the peforma of their official duties. Its conent may not othervise be disclosed without World BAnk athraon.  TABLE OF CONTENTS Page No. EXECUTIVE SUMMARY . ...................... i CHAPTER 1: RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS A. IntrodT tion.. 1 .......... B. Stabilizing the Economy .................. .......... ....... 1 - Introduction . - Demand Management. 2 o Expenditure Switching and Contraction of Dew-and .................. 2 * The Pattern of Central Govermnent Fiscal Adjustment ..... ........... 3 * Fisc,21 Sustainability ...................................... 5 C. The Economy's Response ... ................................ 7 - Introduction .7 - Investment. 8 * International Experiences. 9 o The Response of Private Investment in India ...................... 11 * Summary ..... 16 - Inflation. ..... 17 - Recent Developments in Money and Capital Markets ..... 19 - Balance of Payments ..... 22 * The Current Account . ............................... 22 * Prospects for the Current Account ............................. 23 * The Strengthening of the Capital Account .......... .............. 25 D. The 1994-95 Budget . ...................................... 27 - Highlights ...................... .................... 27 - Fiscal Adjustment .............................. 30 E. Adjustment in State Finance .32 F. External Debt Management and External Financing Requirements .37 - External Debt Management .37 - Extemal Financing .3.9..... 39  Page No. CHAPTER 2: THREE YEARS OF REFORM; SHORT AND MEDIJM-TERM POLICY ISSUES A. Results of Three Years of Reform . .................. ...... 41 - Introduction ................... ........... I . . I.... 41 - The LJ-eralization of Private Investment ... 41 * The Past Impediments to Private Investment .41 * The Liberalization of India's Investment Regime .43 * The Task Ahead .... .......... ......................... 45 - Tne Liberalization of the Trade and External Payments Regime ........................ 45 * Background ......................... 45 * Reforms since June 1991 ........................ 45 o Future Priorities ........................ 45 - Refonning Financial Markets ................................ 46 - Background .................................... 46 * Reforming the Financial Sector . .............................. 48 = Tax Reform .50 - Progress and Shortcomings in Public Enterprise Reform .51 * Background .......................................... 51 * Reform of Putlic Enterprises .................. 52 3 Reform of States' PEs .................. 56 B. Short and Medium-Term Policy Issues .................. 57 * Restoring the Public Sector Capacity to Invest .................. 57 * Prioritizing and Increasing the Efficiency of Public Expenditure .................. 58 * Increasing Private Investment .................. 59 * Managing Capital Inflows .................. 60  Page No. CHAPTER 3: MANAGING INDIA'S ENVIRONMENT - SELECTED ASPECTS A. India's Environment Today ........................ 65 - Evironmental Pollution ........................ 66 * Air Pollution . 66 * Water Pollution .69 * Hazardous and Toxic Wastes .69 - Forests, Wildlife and Biodiversity ............. ............... 70 B. The Current Environmental Management Framework ............... 74 - Overview ..... ...................................... 74 - Environmental Pollution Control .7.5....... 75 3 Institutional Framework .75 3 Standards and Regulations .76 * Fiscal Incentives .76 e Public Expenditure .76 e Monitoring and Enforcement .77 - Conservation of Forests, Wildlife, and Biodiversity .77 Institutional Framework .'17 * Management Strategy .79 v Actions Taken .79 C. Issues and Options .80 - Are the Highest Priority Problems Being Addressed? .80 * Policy Priorities .81 * Pollution Priorities .83 * Conservation Priorities .......................... ........ 85 - Are the Right Strategies Being Employed? ...... 85 - Is the Institutional Framework Adequate? ...... 90 - Is Enough Being Done? ...... 91 D. Concluding Observations ...... 94 STATISTICAL APPENDIX  Page No. TABLES 1.1 Central Government Finances................... .............. 3 1.2 Recent Evolution of the Public Deficit .......................... . . 4 1.3 Evolution of the Public Debt Stock .............. 5 1.4 Interest Rates on Central Government Debt .... ........ . . 6 1.5 Growth Performance .............. 7 1.6 Industrial Growth by Industry of Use .............. 8 1.7 Investment by Type of Lnstitution ............................... 9 1.8 The Relative Size of India's Transfer Problem ..... ......... 10 1.9 Trends in Capacity Utilization-Use-based Classification .............. 11 1.10 Financial Performance of the State Electricity Boards .................. 15 1.11 Evolution of the Wholesale Price Index .......................... 18 1.12 Domestic and International Prices of Wheat and Rice .................. 19 1.13 Key Interest Rates .20 1.14 Issues by Public and Private Companies .21 1.15 Selected Monetary Indi, ators .22 1.16 Balance of Payments ...................................... 23 1.17 Foreign Direct and Portfolio Investments .................... . 25 1.18 Portfolio Investment in Selected Co ntries .26 1.19 Real Exchange Rate of India's Main Trading Ptrtners and Competitors .27 1.20 Central Government Transfers to High and Low Income States .32 1.21 State Govermnent Finances .35 1.22 Devolution of Resources from the Center to State G vernments .36 1.23 India's External Debt .37 2.1 Gross Capital Formation by Industry .42 2.2 Foreign Investment Approvals .45 2.3 Tariffs and Collection Rates-International Comparisons .46 2.4 Tariff Structure .47 2.5 Public Sector and Public Enterprises in the Economy .52 2.6 Financing Central Government PEs' Plan Investments .53 2.7 BIFR Activities, Public Sector .55 2.8 Profitability Profile of non-Departental Central Government PEs .56  Page No. TABLES (continued) 3.1 Ambient Lead ......................... 68 3.2 Trends in Ambient Air Pollution ......................... 68 3.3 Excedences of BOD and Total Coliform Reference Levels .70 3.4 Estimated Area Under Forest Cover ............ ............. I ..... 72 3.5 MoEF Budgeted Expenditures ................................ 75 3.6 Cumulative Enforcement Activity Under the Water aad Air Acts .78 BOXFf 1.1 Constraints to Private Investment in Agriculture ..................... 13 1.2 3tate Power Sector Restructuring . ............................. 16 1.3 Istitutionai Constraints on Private Investment ..................... 17 1.4 Instruments Used by Foreign Direct and Portfolio Investors ............................... 24 1.5 From the 1994-95 Budget Speeh .28 1.6 Main Tax Reform Introduced in the 1994-95 Budget .29 1.7 Transfers of Resources from the Central to the State Governments .3...................... 33 1.8 Fiscal Adjustment in Selected States. 34 1.9 Non-Resident Deposits ..................................... 38 2.1 The Liberalization of India's Investment Regime in Selected Key Sectors ................................. 44 2.2 Case Studies: Hindustan Machine Tools (HMT), Mysore Kirloskar Ltd (MKL), and the National Textile Cororation (NTC) ...................................... 54 2.3 Recent Experiences in Dealing withi Capital Inflows ................... 64 3.1 Some Indicators of Environmental Pollution ........................ 66 3.2 Biodiversity in India ...................................... 71 3.3 NTPC's Environmental Action Plan ......... ................... 77 3.4 EAP Priorities .81 3.5 Development Policies and Deforestation in Brazil and Costa Rica .82 3.6 Environmental Health .83 3.7 hIflexible Standards and Unpalatable Choices .86 3.8 Conflicts Between Growdi and Environmental Quality .87  Page No. BOXES (continued) 3.9 Effluent Charges in Use .................................... 88 3.10 Incoiporating Economic Considerations into Standard Design ................................... ......... 89 3.11 The Sardar Sarovar Jt oject ............... .................. 92 3.12 Trading Off Alternative Development Interventions ................... 93 FIGURES 3.1 Ambient Concentrations of Air Pollution. .67 3.2 Foresuty and Logging--Changes in Output and Prices .73 3.3 Forestry Deflator/GDP Deflator ....................... ....... 73 GRAPH Graph 1 Agricultural Prices in Real Terms: in the World, at the Indian Border, and Domestic ..... 12 This Report has been prepared by a team led by Roberto Zagha. R. Anderson has been responsible for the chapter on environment. The Report was based on contributions by: D. Ahluwalia (.-mnt developments and policies in the agricultural sector), P. Auffret (recent economic developments, selected fiscal issues), P. Beckerman (inancial sector reform), B. Blarel (recent developments and policies in the agricultural sector), M. Haddad (developments in the manufacturing sector), H. Hansen (infrastructure), D. Kantawala (Consultant, environment), S. Kunte (inflation), K. Nyman (powcr sector issues and policies), P. Pollak (developments in the hydrocarbon and coal sectors), V.J. Ravishankar (public finance), C. Rees (environment--forests, wildlife, and biodiversity), S. Sengupta (small-scale industries), L. Serven (fiscal sustainability), K. Siddique (selected public finmce issues), H. Suzuki (public enterprises), W. Thirsk (Consultant, tax reforms), and P. Yagci (industrial policy developments). Statistical and computational assistance was provided by R. Khanna, S. Kunte and E. Simel. Arrangements for the missions were cafied out by P. Gopalan in Delhi. The report was produced by E. Torre with R. Bessette, H.Y. Kim, L. Chin and Z. JI.ieo. The report was prepared under the general direction of Javad Khalilzadeh-Shirazi. The assistance of the Ministry of Finance, Reserve Bank of India, the Ministry of Environment and F - -ts, the Maharashtra State Pollution Control Board, Ministries of Finance of Maharashtra and Tamil Nadu, otw.r government and private institutions in the preparation of this Memorandum is gratefully acknowledged. The Memorandum has been discussed with the Indian authorities in May 1994.  ECONOMIC DEVELOPMENT DATA GNP PER CAPITA IN 1991 US$330 /a GROSS DOMESTIC PRODUCT IN 1992/93 ANNUAL RATE OF GROWTH (% 1980/81 Constant Prices) 65/66- 70/7i- 75/76- 80/81- 85/86- 90/91- 91/92- 69/70 74/75 79/80o 84/8 89i90 91192 92/93 USS BLn. GDP at Market Prices 243.67 100.00 3.0 2.1 3.6 5.6 6.1 1.2 4.6 Gross Domestic Investment 60.89 25.00 1.8 5.0 4.9 2.5 9.7 -15.6 19.9 Gross National Saving 55.61 22.82 - - 1.1 O.O -9.8 23.9 Current Account Balance -5.28 2.20 - - OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1981 Value added (at factor cost) Labor Forct_bL V.A. Per Wcrker USS Bin. % Mil. % US$ % of Nat. Average Agriculture 58.9 38.0 172.7 70.6 341 53.9 Industry 40.1 25.9 31.6 12.9 1268 200.3 Services 55.9 36.1 40.3 16.5 1387 219.1 Total/Average 154.9 100.0 244.6 100.0 633 100.0 GOVERNMENT FINANCE General Government ic Central Government Rs. Bln. % of GDP Rs. BIn. % of GDP 1991/92 _991/92 1986/87-1990/91 1992/93 1992/93 1987/88-1991/92 Revenue Receipts 1247.75 20.3 20.5 741.28 10.5 10.9 Revenue Expenditures 1483.58 24.1 23.7 927.02 13.1 13.8 Revenue Surplus/Deficit -235.83 -3.8 -3.2 -185.74 -2.6 -2.9 Capital Expenditures /d 238.95 3.9 6.4 215.99 3.1 5.0 Externat Assistance (net) Le 54.21 0.9 0.7 53.19 0.8 0.7 MONEY. CREDIT AND PRICES 75/76 80/81 85t86 86/87 87/88 88/89 89/90 90/91 91/92 2/93 (Rs. billion outstanding at end of period) Money and Quasi Money 224.8 557.7 1194.0 1416.4 1642.8 2002.4 2309.5 2658.3 3174.8 3626.6 Bank Credit to Government (net) 106.3 257.2 583.2 720.2 843.7 973.7 1171.5 1401.9 1582.6 1760.9 Sank Credit to Commercial Sector 156.2 366.4 828.0 947.4 1074.9 1326.6 1517.0 1717.7 1879.9 2163.7 (Percentage or Index Numbers) Money and Quasi Money as % of GDP 30.3 41.0 45.6 48.5 49.3 50.5 50.9 50.1 51.6 51.4 Wholesale Price Index (1981/82=100) - - 125.4 132.7 143.6 154.3 165.7 182.7 207.8 228.7 Annual Percentage changes in: Wholesale Price Data - - 4.4 5.8 8.2 7.5 7.4 10.3 13.7 10.1 Bank Credit to Government (net) 22.7 28.5 15.8 23.5 17.1 15.4 20.3 19.7 12.9 11.3 Bank Credit to Commercial Sector 22.7 18.2 16.7 14.4 13.5 23.4 14.4 13.2 9.4 15.1 /a The per capita GNP estimate is at market prices, using World Bank Atlas methodology. Other conversions to dollars in this table are at the prevailing average exchange rate for the period covered. Lb Total Labor Force and percentage breakdown from 1981 Cenus. Excludes data for Assam. LE Transfers between Centre and States have been netted out. Ld All loans and advances to third parties have been netted out. Le As recorded in the government budget.  BALANCE OF PAYMENTS 1991/92 1992/93 1993/94 (USS million) MERCHANDISE EXPORTS (AVERAGE 4988189-1992/93 la) Export of Goods /a 18223 18789 22560 US$ mill X Imqorts of Goods is 20347 22895 23660 Trade Balance -2124 -4106 -1100 Tea 480 2.8 Non Fac.or Services (net) 676 220 565 Iron Ore 515 3.0 Chemicals 1265 7.4 Resource Balance -1448 -3886 -535 Leather and Leather products 1245 7.3 Textiles 1898 12.0 Garments 2046 12.0 Interest Income (net) Lb -4127 -3591 -3?22 Genm and Jewelery 299Z 17.6 Net Transfers /c 2685 2200 3500 Engineering Goods 2077 12.2 Others 4514 26.5 Balanc; on Current Account -2890 -5217 -757 Totat Froeign Private Investment 148 435 4100 Official Grants & Aid 426 356 S00 Net Medium & Long-term Capital 3767 2544 5181 Gross Disbursements 7020 5539 8880 Principal Repayments 3254 2995 3699 EXTERNAL OEBT. MARCH 31. 1993 USS Million Other Capital Flows /d 1614 -269 -1281 Non-Resident Deposits -454 1949 656 Net Iransactions with IMF m 1289 191 Outstanding and Disbursed 91579 Errors and Omissions Change in Gross Reserves -3314 -1027 08590 Gross Reserves (end of year)L_ 5;a2 6749 15339 DEBT SERVICE RATIO FOR 1992/93 /f 29.8X Fuel and Related Materials I1RD/IDA LENDING, MARCH 31. 1993 US$ Million loports (Petroteum) /a 5325 5919 5762 IBRD IDA of which: Crude 3194 3711 n.a. Products 2131 2208 n.a. Outstanding and Disbursed 9067 15339 Undisbursed 5929 4572 Outstanding including Undisbursed 14996 19911 RATE OF EXCHANGE End-March 1994L/ US$1.00 a Rs. 31.37 i La Met of crude petroleun oil exports. /b Figures given cover all investment income (nMt). Major payments are interest on foreign loans and charges paid to IMF, and major receipts is interest earned on foreign assets. Lc Figures given include workers, remittances but exclude official grant assistance which is incl-ded within official loans and grants, and non-resideint deposits which are shown separatelt. Ld Includes short-term net capital inflow, changes in reserve valuation and other items. La Excluding gold. /f Amortization and interest payments on foreign loans as a percentage of total current receipts. Lg The exchange rate was reunified at :he market rate in March 1993.  India: Priority Poverty Indicators Mos Sameregiem4ncomegroup Atas 25.30 15.20 rerwu higher Unit of yeaw yean evliate South LO% um" ndicastor measur a8e ago (ns) A4sa income group POVERTY Uppe, poverty lute looal wr. -. 1,296 Headcount index %of pop. 43 25 Lower povety line Plal curW. Headaourt index %o ofpop. GNP per capita U1,$ 90 160 330 320 350 1,610 SHORT TERM INCObE INDICATORS Wdnkilbd uba wages local cwrr . .. .. . .. Unskilled uran wagas ^ ,... Rural tem oftade. 84 94 Consumepriceindex 1987J100 19 4s 144 Lower income .. .. Food 147 Urban Rural SOCIAL INDICATORS Publcic eXndiwe on basic social savia %Of GDP .. .. .. Cross enrollmerd ratio$ Pmary %acdcolagepop. 74 79 97 95 113 100 Male 89 94 109 106 122 106 Faeale 57 62 83 8? 106 98 Mo"aity infaut motality tbou. iive biets 150 130 90 92 70 40 Under S morWtaity .. .. 124 128 98 53 Immunization MeaSles %ageV UP .. .. 56 57 73 70 DPT .. .. 79 75 81 74 Child malnUtrition (unde-5) .. 49 Life expeAncy Total years 47 52 60 59 63 67 Femalestmlles ratio 0.97 0.98 1.01 1.01 0.95 1.08 TOtal fertility rate bthparwmoan 6.2 5.3 3.9 4.2 3.7 3.5 Mateal moraity rae 100,000 live biths .. .. .. Population growth rate Infant ortality rate Primary enrollment (pecat) (thom. oflive births) e 6+T 250 120+ ~~~~~~+ ~~~~~~~~200 100 150 3 ~~~~~~~~~~~~~~~~~~~60 100 2 ~~~~~~~~~~~~~~~~~~~~40 20 mid 60s ud 70s an rid 60s n:3 MM mid 605 wt. 708 mm - Lowue  lndia: Resources And ExPenditures AMos Same rgi.wtww 4oua.p New Unit ~~~f Yon yewsa aimgate South o- Ics lndadlse mseauwe ag0 age (fie) Asia b3come aw HUMAN RESOURCES Pogukdoo(nui-1991) anfilion 487 613 866 l.'52 3,127 774 Age depedency raio ratio 0.78 0.77 0 70 0.73 0.66 0.71 Urban % of pup. 18.8 21.3 27.0 26.0 40.1 53.9 oFoulatinollVwihrame maftlu% 2 3 2.3 2.0 2.1 1.9 1.7 Ukbao 3.2 3.7 2.0 2.8 5.2 3.1 IAborforvee(15-64) wilioam 207 243 32.9 420 1,44* 302 Agriculture %~~~~~~~of labor forme 73 71 . 12 1 3 Female 3 1 28252333 Fans!. per 100 males Urban number . 88 . Rural - 94 . NATURAL RESOURCES Anet thou. sq. kmn 3,288 3.288 3.287 5.133 38.82* 23.990 Density pop. j qkm148.0 187.0 253.0 215.0 77.0 31.0 ApwulbxaJ land ~~~~~%Orland am 59.6 60.8 60.9 58.9 47.4 41.8 Chang. in agricultural land minus! % 0.3 ~~~~0.5 .010.0 0.0 0.0 AahwallndundkW rrigatioe 15.0 18.6 23.2 26.2 13.7 12.6 Foredsland woodland thou.sq. km 612 656 667 809 9,197 5.396 Dfoofacsaion(tw) annual % 0.3 40.2 40.2 IN#_,:.k4E HouaWid niawn Shiareftop 20% of households %Of inome 49 49 . Shatedb~ofm40% ofhoudaotde 1 7 1 6 Slaareofbottom 20% ofhousebold 7 6 * EXPENDITURE Food %ofGDP .. 43.6 35.3 36.2 .. 20.6 12.4- Maatfiah.malk deae.. 6.5 7.4 c4tw nmpcsug tou. mehric tooncs 7.878 7.669 447 5,596 36,008 44.418 Food aid in combg. 1,582 456 2,408 6,669 4,047 FoodprodtNtionpercapits 1979;1=100 90 101 1I8 113 122 101 Fafiiwmuuiriakg/ha 5.0 21.0 53.0 57.5 47.5 94.2 Shareof arulreiGDP %*oGDP 40.6 36.6 28.6 28.6 28.7 Hauling %ofGDP ..4.4 7.1 Awags household size persori par houschold. 5 Urban ..5 Faxd oveesunat housing %ofGDP ..2.3 2.8 Fuel ind power %ofODP ..2.4 2.3 Ewgycomum~~ionpa'capita ~ kgo of lequiv. 10131 231 207 350 1.49 Households with aelablicity tkban % ofbouse dole. .. Ruram . ., Trmopct sa commdcad%ofGDP ..4.7 5.1 Fj=d nveonea-koiiIV m~ p .. d1.4 2.3 Tow 1road km* O thukmn. 1.215 . INVESTNMEN IN IWMAN4 CAPITAL Heaubh Acne to heaft car %of pOp. . .. Papalai n per physician persmi 4.880 4.900 2,459 2,459 PopuIslion per nums 6.500 3,710 I ..,0i" Pcpulation perbhoapit bed .. 1,700 1.71 1648 10459 Aaousto saie wat %ofpOp. .. 31.0 73.0 70.3 70A6 Ufban 0 . 0.0 82.0 76.5 79.3 RtaW ~~~~ ~ ~~~~~~~~~18.0 69.0 66.9 62.8 Oral r-hdyrali theap(undu 5) %ofou . . 13 189 32 EAueatUe (kms enrolwdlnaiatio Seconday %ofsocool'ageepop. 27 26 44 39 44 56 Feumal 13 16 33 3!1 37 Pupi4eadae ratio: prunay Pupils paoer er42 42 61 59 39 25 pupfl4eadierrfatio:aeooaday -22 21 23 23 20 p...s fgcA.j Vsdo 4 %ochot. SI . Repeaterrate:primary %oaftoeaenrohl 20 17 44 Illteacy % otpop. (Sp ls+) 52 ..54 39 Fenit. % offean.(agel+) . .66 68 52 Newswupapcirelioa per thou pop. 13 15 . Soam: World Bank Intewationa E4onotnics Departmen Apari 1993  EXECUTIVE SUMMARY 1. In July 1991, a new goverrnent started to liberalize India's economy with a reform program focused on the investment regime, trade policies, the fiancial sector, taxation, and public enterprises. The reforms' major objectives were to reduce the capital intensity of India's growth process, lessen its reliance on the unsustainable expansion of the public sector, and thus translate the country's relatively high investment rate into high and sustainable growth of output and employment. Compounding the difficulties inherent in any liberalization process, the government also faced serious fiscal and external imbalances which had generated double-digit inflation and put the country on the verge of def4ulting on its external debt obligations. 2. Over the last three years, notwithstanding a sharp increase of the fiscal deficit in 1993- 94, the government has made considerable progress in reducing non-interest expe- litures. It has been remarkably successful at improving the country's current and capital exteri ,i accounts. And it has introduced structural reforms which have significantly liberalized the economy. Carried to their logical conclusion, these reforms could enable India to grow at the rates experienced by its successful East Asian neighbors. Transfonning this possibility into reality requires intensified efforts to strengthen public finances, improve infrastructure, and enable private investment to flow into key areas of the economy. In turn, this entails broadening the process of reform, which has thus far been dominated by a few central ministries (Finance, Commerce, Industry), to sectoral ministries, public enterprises, and state governments. In this context, intensified efforts at strengthening social safety nets are also needed. A. The Economys Resonse 3. The response of the economy to the stabilization and reform measures implemented since July 1991 has been generally positive, but macroeconomic stresses brought about by the reform program pose new challenges for policy. Growth recovered from 2 percent in 1991-92 to around 4 percent in the last two years. Industrial production and investment have been slower to recover from the deflationary effects of the initial stabilization measures. After declining to negative 2 percent in 1991-92, manufacturing growth recovered to a modest 2 percent in 1992-93 and 1993-94. While this deceleration is modest compared to that experienced in other countries' stabilization and reform experiences, the authorities have been justifiably concerned by declining investment rates. The improvement in India's external accounts, both current and capital, has exceeded the most optimistic forecasts. With exports rising by 20 percent in 1993-94, modest growth of imports (partly the result of slow growth in rianufacturing), and an improvement in the service account, the current. account deficit declined to US$0.8 billion in 1993-94 (0.3 percent of GDP), from US$10 billion in 1990-91 (3.5 percent of GDP). At US$4.7 billion, foreign investnent (largely portfolio investment) surged to unprecedentedly high levels. As a result, reserves increased from about US$1 billion in June 1OC1 to US$15 billion by end-March 1994. The monetization of reserves, however, has led to a sharp expansion in base money-25 percent in March 1994 in relation to March 1993. Together with significant increases in administered prices, this has contributed to inflauon. After declining from a peal of 17 percent in August 1991 to around 7 percert in mid-1993, inflation has increased again, exceeding 10 percent in early April 1994.  - ii - B. StabUiing the Economv 4. In July 1991, the government's highest short-term priority was to stabilize the economy through expenditure switching and contraction of aggregate demand. The rupee was devalued in July 1991, and floated in March 1992. It fell from Rs 21/US$ in June 1991 to Rs 31/US$ in March 1992, and has remained at about this level since then. Mostly through expenditure cuts (on subsidies, defense, capital expenditure, and loans to states and public enterprises), the central government fis.al deficit was reduced from 8.4 percent of GDP in 1990-91. to 5.7 percent of GDP in 1992-93. Base money growth was maintained at 11-13 percent per year against a nominal GDP growth of 15-16 percent. Much of this progress was lost in 1993-94. The fiscal deficit escalated to an estimated 7.3 percent of GDP, against a target of 4.7 percent of GDP, as a result of both revenue shortfalls (40 percent of the deviation) and expenditure overruns (60 percent). Base money growth rose to 25 percent basically as a consequence of the monetization of capital inflows which were particI-larly strong in the first few months of 1994. To contain the inflationary impact of this increase in liquidity, the RBI increased in May 1994 reserve requirements by I percentage point, but the build-up of primary liquidity is likely to continue putting pressure on prices in the near future. 5. About 1 of the 2.6 percentage points of GDP fiscal deviation in 1993-94 is estimated to be the result of tax revenue shortfalls resulting from a weak economic recovery. The remaining 1.6 percentage points are accounted for by expenditure overruns, mostly on subsidies (0.5 percent of GDP), defense (0.3), loans to states (0.3), and public enterprises (0.1). The deviation in 1993-94 notwithstanding, total non-interest expenditure has fallen significantly, from 15.8 percent of GDP in 1990-91 to 13.3 percent of GDP in 1993-94. In addition, the 1993-94 fiscal outcome accommodates the considerable fiscal cost of the structural reform program underway such as forgone revenues because of lower tariffs, higher interest payments on the government debt because of the liberalization of interest rates, and retrenchmene costs associated with public enterprise reform. In relation to 1992-93, these costs amount to 0.8 percent of GDP. 6. However, the worsened 1993-94 fiscal performance could undermine the credibility of the fiscal adjustment process, unless future fiscal performance shows it to have been an aberration. At 66 percent of GDP by end 1993-94, the central government debt (90 percent of the consolidated central and state governments debt) is relatively high. Interest payments already claim over half of central government fiscal revenues. The financial sector reforms underway and the reduction in central govermnent recourse to RBI credit over the next few years (para. 7) will further increase interest rates on the government debt (para. 15) and compound the problem. Taking into account these higher real interest rates, stabilizing the central government debt in relation to GDP at its March 1994 level-a minimum objective for sound public finances- -requires the primary deficit to be reduced by 1-2 percent of GDP beyond what is envisaged for 1994-95. Unless the 1994-95 fiscal deficit target of 6 percent of GDP is met (a difficult objective since the 1994-95 fiscal deficit target is based on the assumption of a recovery, paras. 7-9), and decisive steps are taken to reduce it further in 1995-96, the central government fiscal deficit could endanger India's economic prospects. Strong improvement in the finances of the central government need to be accompanied by improvement in the finances of public enterprises and the states. Over the last few years, the states' deficit has remained at around 3 percent of  - iii - GDP at the cost of expenditure cuts. This has accentuated a trend started in the mid-1980s. Since then, the deterioration of the states' finances has affected the provision of key social and economic services. C. The 1994-95 BudRet 7. The 1994-95 Budget presented to Parliament on February 28, 1994 is this government's fourth. While continuing the process of structural reform in several key areas, in particular taxation (para. 19), its major objective is to reactivate investment. First, to lower the user cost of capital, the government has: (i) reduced tariffs on capital goods imports (as part of a new round of tariff cuts); (ii) reduced the minimum lending rate by one percentage point; (iii) allowed firms to take credit for excises paid on purchases of equipment, as part of a major reform of excises; and (iv) unified and reduced the tax on corporate income to 46 percent, from 52 percent for "widely held" companies and 58 percent for other companies. Second, the Govermnent indicated that barriers to private sector entry in areas still reserved for public sector investment (telecommunications, hydrocarbons, coal) would be reduced further. The government also announced it would consider the recommendations of an expert committee to liberalize the insurance industry, currently a public sector monopoly. The fiscal deficit target for 1994-95 is set at 6 percent of GDP, to be achieved entirely by a reduction of expenditure in relation to GDP. Non-interest expenditure is projected to decline from 13.3 percent of GDP in 1993-94 to 11.7 percent of GDP in 1994-95 (i.e. about 4 percent of GDP in relation to 1990- 91). The decline in expenditure notwithstanding, the Budget has increased by over 50 percent the allocaton for rural emplovment and related program (which now account for 0.5 percent of GDP) for areas with the highest incidence of poverty-the large volume of resources now allocated to these programs makes it improving their cost effectiveness more urgent than ever before. On the revenue side, a reactivation of the economy together with improvements in tax policies which have made it possible to improve tax administration are expected to offset the decline in rates of customs, income taxes and excises and so maintain revenue constant as a percentage of GDP in relation to 1993-94. While the 1994-95 target is modest compared with the 4.7 percent of GDP target for 1993-94, and implies only partial correction of the fiscal overrun in that year, its achievement may require additional and timely expenditure and revenue measures as the year unfolds (para 9). Finally, in presenfing the budget, the government also announced its intention to phase out the monetization of the fiscal deficit over a period of three years. 8. The Government fully recognizes the necessity of strengthening central govermment finances. As indicated in the Ministry of Finance's most recent Economic Survey (February 1994) "it is vital to reassert control over the fiscal situation to curb inflation, reduce interest rates, release resources for productive investment and sustain confidence in the econony." However, two considerations have led the government to limit the extent of fiscal deficit reduction in 1994-95 and set a fiscal deficit target higher than that in the previous fiscal year. First, the central government's discretion on controlling its expenditure is increasingly limited in the short run. Of total expenditure budgeted for 1994-95, 79 percent is accounted for by interest payments (31 percent), defense (15 percent), wages (10 percent) and grants and loans to the states (most of which are mandated by the Constitution, 23 percent). On the revenue side,  - iv - the radical tax reforms being introduced, including significant tariff reductions, render it difficult to increase tax revenues beyond what is anticipated in the budget. Second, as indicated in the Minister of Finance's Budget Speech, the government takes the view that the short-term macroeconomic consequences of the fiscal slippage and of the partial correction envisaged for 1994-95 are unlikely to be severe and that a stronger recovery is needed to prevent a further deterioration of public finances. In 1993-94, the current account deficit of the balance of payments declined to 0.3 percent of GDP. At US$15 billion, reserves are at their highest level ever. Significant capacity underutilization is widespread in manufacturing. A significant part of inflation has been caused, on the supply side, by increases in administered prices and agricultural prices catching up with their interiational equivalents and, on the demand side, by the expansion in monetary aggregates resulting from the surge in capital inflows. The gove,nment has thus given priority to stimulating investment through the introduction of key structural reforms with the expe'Eation that with more income-elastic sources of taxation now in place, a recovery of growth would improve tax collections, and thus increases in tax revenues would play a larger role in fiscal consolidation in the future. It should be clearly recognized, however, that continued high fiscal deficits pose the most serious single threat to the attainment of India's medium-term development objectives. 9. A key question about the 1994-95 budget is whither it will be successful in stimulating private investment. While the budget has reduced tL user cost of capital, what is holding private investment back may not be so much high user cost of capital, as the significant idle capacity in sectors where private investment can now most easily flow in (e.g., manufactuning); meanwhile in sectors where there is an urgent need to expand capacity, a policy and institutional framework supportive of private investment is not yet in place, and barriers to entry have not yet been entirely removed. To reach its reactivation objectives, it is thus urgent that the 1994-95 Budget be supported by continued sector-level reforms addressing remaining policy constraints deterring private investment in key sectors of the economy (paras. 29-30). Even if these measures are implemented rapidly, however, the recovery of the economy may take longer than anticipated by the government and cause tax revenues to be below the levels projected in the Budget. In addition, experiences from other countries suggest that the short-term revenue effect of a major tax reform such as the one introduced in the last budget (para. 19) is extremely difficult to predict; the uncertainty associated to the tax projections in the Budget is consequently greater than normal. Thus, in the course of the current fiscal year, additional resource mobilization measures (such as acceleration of disinvestment) or further e-xpenditure cuts may become necessary to ensure that the 1994-95 fiscal deficit target is met and inflationary expectations are dampened. D. Reforming the Economy 10. The program of reforms has been carefully prepared. Since July 1991, the government has appointed several high level committees of experts to formulate reform proposals in the different reform areas, which it has generally accepted. The committees' reports and government policy papers have been madt public and amply discussed with academics, industialists, and unions. This approach has helped the government build consensus around thc economic program, anticipate public reactions to reform measures, and avoid the reversals that  v have sometimes derailed adjustment programs elsewhere in the world. Equally important, it also enabled the government to avoid errors in the sequencing of reforms. The liberalization of product markets (through the dismantling of licensing which regulated investment and trade) preceded the liberalization of factor markets (achieved partly through the liberalization of financial markets). A sharp devaluation (in July 1991) preceded the lifting of quantitative restrictions on imports of internediates and capital goods which had in turn preceded reduction in tariffs. In reforning the financial sector, the government has been aware of the need to improve prudential regulation and banking supervision ahead of recapitalization of banks to reduce the likelihood of further decapitalization in the future. The deregulation of interest rates has been introduced in steps ttiat have avoided the problems that sudden financial decompression has created in many Latin Americarn countries. In short, while several more years will be necessary to complete the process which has started in July 1991, and difficult reforms are yet to be introduced, the skill with which reforms have been introduced thus far has few parallels elsewhere and enhances the credibility of the reform process. Part of the government's success in articulating and implementing a coherent mix and sequencing of reforms stems, howe'ver, from the fact that the process has thus far been driven by a few central ministries (Finance, Commerce. Industry) and the RBI. The full potential benefits of India's reform program will only materialize if the process is extended to sectoral ministries, public enterprises, and state governnents--whcre the sh.eer n.m.umber of players will make achieving consensus and c ordinating policy reforms a much more arduous task. 11. LiberaEzation of the Investnent Regime. Sectors previously reserved for public investment such as power, telecommunications, mining, ports, roads, river transport, air transport, and banking are now open to private investors. In areas not previously reserved for public investment (such as manufacturing) the government has also dismantled the previous investment licensing regime. Similar measures have been taken regarding foreign investment, which has risen from less than US$200 million a year in the early 1990s to US$600 million in 1992-93, and to US$4.7 billion in 1993-94. However, sector level impediments to private investment remain (paras. 29-30). 12. Liberalization of the Trade Regme. Licensing requirements on imports of intermediates and capital goods have been eliminated. Several rounds of tariff cuts have reduced maximum tariffs from 400 percent in 1990-91 to 65 percent at present, and the import-weighted average tariff from 87 percent to 33 percent. The government has also indicated that over the next few years remaining licensing restrictions on imports (of consumer goods) would be eliminated. As a preliminary step, the most recent Export-Import Policy (April 1994) modestly expanded the scope of a special license scheme for imports of consumer goods. However, restrictions on consumer goods imports remain pervasive and a bolder approach is warranted to eliminate them. Regarding tariffs, the government indicated that maximum tariffs would be reduced further over the next two years, to 30 percent on intermediates and 20 percent on other goods. Finally, the government has liberalized the foreign exchange market. The rupee was floated in March 1992 and near full current account convertibility established in March 1994. 13. Reform of the Financial Sector. With a financial savings rate over 13 percent of GDP in 1990-91, India has been successful at developing a large financial sector, and one of the  - vi - largest capital markets in the developing world. However, India's financial system has been weakened by inadequate incentives for allocating financial resources efficiently, heavy regulation of returns on financial assets, and restrictions on competition. 14. Over the last three years, the government has taken a number of measures which have liberalized the financial sector and strengthened its institutions. Firs, financial institutions' discretion over portfolio composition has increased and incentives for efficient use of funds improved. Commercial banks' forced holdings of government debt have been reduced, subsidized credit to priority sectors has been rationalized and its cost to the financial system reduced though an increase in rates; and controls over banks' lending decisions have been relaxed. In April 1992, the RBI issued new prudential guidelines for income recognition, asset classification, and provisioning requirements, and adopted the Basle Accord capital adequacy standards, to be reached by all Indian banks by March 1996. Bank supervision is being strengthened. The new more exacting prudential standards have forced the banks to increase their provisions and show losses in 1992-93 for the first time in recent history. They also made it evident that commercial banks, the public banks in particular (which account for 94 percent of banks' assets), needed to strengthen their capital base. 15. Second, interest rates controls have been relaxed and restrictions on firms' access to capital markets removed. While a minimum lending rate and a maximum deposit rate remain, interest rates in areas such as certificates of deposits, debentures, commercial paper and most government securities are now market determined. The development of government securities markets has been accelerated with the Government decision to phase out the monetization of the fiscal deficit and the May 1994 RBI decision to establish a system of primary dealers. Since September 1992, foreign institutional investors have been allowed to invest in all non- government securities traded in India's primary and secondary markets, including debentures and shares of private and public enterprises--up to 24 percent of issued share capital in any one company. The tax rate on capital gains is 30 percent on gains realized before one year, and 10 percent thereafter. 16. Third, public banks are being made more autonomous and their capital base is being strengthened both through direct budgetary support and changes in legislation enabling them to mobilize resources from the market. For example, the State Bank of India, which accounts for one-thi-d of public banks deposits has already raised US$700 million of fresh capital in December 1993. Competition is increasing; nine new banks (three foreign) have been authorized to set up operations (at present there are only 46 private banks, of which 23 are foreign). 17. Reforming the Tar SAstem. At 16-17 percent of GDP for central and state governments combined, and although it needs to be increased, India's tax effort is relatively high. Five taxes account for 95 percent of total tax collections: customs, excises, sales taxes, and taxes on corporate and personal income. The sales tax is administered by the states, but all others are administered by the central government. All these taxes suffered from the common problem of high and highly differentiated tax rates falling on a narrow base. For example, until the last budget, collection of excises was based on high and highly differentiated rates on manufacturing products, numerous specific rates, very partial rebating of excises paid on inputs, and collections  - vii - based not on invoices, but on a notional price n-gotiated with the central government. Together with several hundred exemptions, this opaque and highly differentiated system complicated tax administration, and encouraged litigation. 18. In addition, sharing of revenues with the states from the personal income tax (85 percent of revenues), and excises (45 percent), has led to serious allocative inefficiencies. It has not elicited responsible expenditure behavior on the part of the states because their expenditure decisions did not have to be accompanied by resource mobilization efforts. It has led the central govermnent to concentrate on taxes which are not shared with the states, which also are those with high efficiency costs. Revenues from the corporate income tax (not shared wi}h the states) have doubled in relation to non-agricultural GDP over the last four decades, while revenues from the tax on personal income (shared with the states) declined by about half. In relation to GDP, revenues from tariffs on imports (not shared with the states) more than doubled between the early 1970s and the late 1980s. 19. Based on the January 1993 recommendations of a high level Tax Reform Committee, the government has formulated and begun implementing a comprehensive tax reform program to rationalize the tax system, which has been accelerated in the last Budget. Since July 1991, there have been dramatic reductions of tariffs. Significant further cuts were introduced in the last Budget which also sought to rationalize (by bringing tariffs on inputs below those on outputs) the tariff structure for major groups of goods (in particular capital goods; metals and metal products; and petrochemicals); and eliminate about 350 of the existing 500 exemptions. The 1994-95 Budget has also reduced taxes on corporate income and implemented a major and comprehensive reform of excises. As a major step towards a value-added tax, the government has extended the coverage of MOD VAT (a "modified" version of a value-added tax) to include manufacturing sectors thus far excluded and, for the first time, some services. Of particular importance also are the decisions to shift most excise rates from specific to ad-valorem to increase buoyancy, reduce the number of rates, reduce the number of exemptions by about half, and simplify the administration of the system by relying on invoices for value determination. These reforms have considerably simplified and modernized India's tax system and make it possible for the central govermnent now to focus its efforts on improving tax administration and enforcement--which will need to be the next priority. However, sharing of tax revenues with the states and the inefficiencies associated with the states' sales taxes are serious problems remaining to be addressed. Unless the states also undertake a comprehensive reform of their tax systems with a view to broadening the tax base and increasing revenues, their fiancial difficulties are likely to persist. 20. Reform of Publc Enterpnses. India's public enterprises (PEs) manage 55 percent of the economy's capital stock (excluding households') and generate one-fourth of the country's non- agricultural GDP. In July 1991 the central govermnent announced a three-pronged strategy to improve PEs' weak funnces and economic performance consisting of: (i) eliminating PEs' privileges such as protection from external and domestic competition, and preferential access to the budget and bank resources (through forced holding of government debt); (ii) restructuring potentially viable PEs, liquidating the others, and establishing a safety net program to cushion the social cost; and (iii) providing PEs greater autonomy and the mandate to become profit-  - viii - oriented. Although small blocks of shares were sold to the public to mobilize fiscal resources, privatization was not part of the strategy to reform PEs. 21. While there have been improvements in the performance of some PEs, this approach, on the whole, has not been successful. Partly because of the strength of labor unions, and reflecting the perceived generally weak political support for PE reform, PEs' managers have not been given the authority to introduce necessary restructuring measures such as large scale retrenchment, corporate reorganization, closurc or selling of units, or joint-ventures with private investors. These actions have had to be approved one-by-one at the highest political level in a time-consuming and often inconclusive process. In a large number of cases, large scale disinvestment would wpear to be the fastest and surest way to transform India's public enterprises into profitable and financially sound commercial concerns. It would also help reduce the fiscal deficit. However, the government has not yet accepted the recommendations of the Rangarajan Committee (disinvesting up to 49 percent of equity for PEs in areas still reserved for public investment and over 74 percent in the others). 22. It is essential that the government accelerate the pace of PE reform. Where restructuring exercises must precede large scale disinvestment, Pes' managers need to be given the authority to mobilize the resources necessary for financial restructuring, undertake large scale retrenchment, and associate interested private parties where possible. In April 1994, the government decided to set up an "empowered" committee under the chairmanship of the Minister of Finance to identify the most pressing cases for restructuring of chronically loss-making PEs to which the limited budget resources available for this purpose should be applied, and to accelerate closure of the remaining chronically loss-making PEs. This welcome decision needs to be extended to all PEs in need of restructuring or accelerated disinvestment. Unless such a pragmatic approach is adopted quickly, the financial position of public enterprises will deteriorate as domestic and external competition increases, and this will ultimately put pressure on the budget. Because they are so important in the economy, any delay in improving the performance of PEs will also seriously hamper the prospects of a recovery. E. Short and Medium-_Tem Polic Issues 23. The authorities have been remarkably successful at engineering a thorough transformation of India's economic policies without the disruptions which have typically accompanied such experiences elsewhere in the world. The process is obviously far from complete. The fiscal deviation in 1993-94 has raised considerable concern about the extent and future path of the fiscal adjustment process. Accordingly, there is a clear need for articulating a credible medium- term fiscal adjustment path. In addition, remaining licensing restrictions on consumer goods imports need to be eliminated and tariffs reduced further. Successful completion of financial sector reforms will require additional steps to increase the public banks' autonomy and profitability, and the rehabilitation of the rural credit delivery system. Now that central government tax policies have been improved, there is a need to strengthen tax administration and enforcement. Tax reforms need to be extended to the states and the system of intergovernmental transfers needs to be reviewed. The restructuring-cum-disinvestment of public enterprises needs to be accelerated. In the short term, however, in addition to restoring the credibility of the  - ix - 1994-95 fiscal target, the major problem facing the authorities is how to maintain the dynamism of an economy which has been historically driven by a fiscally unsustainable expansion of the public sector. 24. To address this problem, the full implementation of the reform program needs to be complemented by (i) an increase in public savings enabling the public sector deficit to decline while expanding public investment in areas where it complements the private sector; (ii) as recommended in the February 1993-94 Economic Survey, a reevaluation of all ongoing or planned public investment projects to ensure that they are economically viable, are directed towards the most urgent investment priorities, and cannot be undertaken by the private sector; (iii) the establishment of sector-level institutional and policy frameworks conducive ta private investment in the context of an overall incentive regime leading to efficient allocatior, and utilization of resources; and (iv) measures to offset the impact of capital inflows on the competitiveness of the real exchange rate to ensure the continued expansion of exports. 25. Restoring the Public Sector Cavpftt to Invest. With investments at about 10 percent of GDP in recent years, India's public sector has had a major role in allocating the country's savings (22-24 percent of GDP). Public enterprises are responsible for three-fourths of public investment, and the central and state governments for the remaining one-fourth. At around 2 percent of GDP, however, public savings have been insufficient to sustain such investment levels. They reflect several adverse fiscal developments which became particularly severe during the 1980s: high and growing current spending; low profits of PEs; and inadequate cost recovery, particularly at the state level. The Eighth Plan document indicates that cost recovery rates for economic and social services provided by the states have been declining steadily and that the resulting fiscal drain amounts to several percentage points of GDP. 26. Improved public savings performance by the central government, public enterprises and states is key to the success of India's economic program. It would not only help reduce fiscal imbalances, but also help reverse the anti-investment bias of fiscal adjustment and thus the declining trend in growth of public investment that started in 1991-92--a reversal that needs to be accompanied by an improvement in the quality of public expenditure (para. 27). For the central governnnent, this implies mobilizing resources through a reduction in wasteful expenditure, including poorly targeted subsidies, and better tax administration. Reducing public enterprises' claims on the economy's savings requires accelerating their restructuring and disinvestment. Improving public savings at the level of the states requires improved tax systems and cost recovery. In addition, it may be necessary to establish a system of intergovernmental transfers which at the same time provides resources to the poorest states to accelerate their development, and provides to poor and rich states alike incentives to mobilize and use fiscal resources efficiently. Concerns about interstate 'equity" may neeL to be replaced by a more pragmatic focus on India's poorest states, while increasing the financial autonomy of the richer states where there is a scope for increasing taxation, and mobilizing resources from domestic capital markets. The current practice whereby the central government plays the role of a development banker by providing loans for states' infrastructure projects may need to be reviewed. Unlike a development banker, the central govermment does not associate conditions to its lending to ensure that projects it finances are undertaken within a financially sustainable  framework. Existing financial intermediaries could take over this development bank function and gradually become responsible for financing infrastructrte projects at the state level. 27. Prtiofdzation of Public ExpendYture. While the objective of the reforms underway is to increase the role of private investment in the economy, public sector investment will remain important when directed to productive projects that complement and stimulate private investment. Ensuring this requires careful reexamination of ongoing expenditure programs. Valuable expenditure programs such as road construction cor rehabilitation of irrigation systems are underfunded at present while programs that could be undertaken by the private sector, or programs with negligible economic or social returns to the economy, continue. To address this issue, the Eighth Plan document has recommended independent "zero-based" evaluations of existing government agencies to eliminate those that are redundant, have outlined their usefulness, or have turned out ineffective in practice. The 1993-94 Economic Survey of the Ministry of Finance has extended this recommendation to all expenditure programs. This extremely imnportant recommendation should be implemented as soon as possible. 28. Increasing Private Investment. Declining private investment has been a frequent response to stabilization and reform experiences elsewhere in the world; a natural pause follows major changes in the incentive regime as old projects are reassessed and new projects are formulated. However, structural weaknesses inherited from the previous policy regime may delay private investnent recovery, and need to be addressed. Private investment in India has historically been concentrated in agriculture and manufacturing. Private investment in agriculture has been declining since the early 1980s as a result of (i) a policy framework which fragments India's domestic agricultural markets and restricts private investment in wholesale trade, storage and agro-processing; (ii) declines in public investment, which has been historically important in stimulating private investment in agriculture; and (iii) implicit taxation of agriculture through a number of crude policy instruments such as external trade restrictions and domestic price interventions. In manufacturing, large unutilized capacity ma) discourage new investment in the short run. 29. Opening new sectors of the economy (para. 10) has not yet led to a surge of private investment. In cases such as mining, the opening is too recent (February 1994). In the case of telecommunications, the National Telecom Policy of May 13, 1994 represents a radical change in that it aims at ending the monopoly of the Department of Telecommunications (DOT) in the provision of basic telecommunications services. But again in this case, the change is too recent and it will take some time before the change in policy is implemented and translated into a regulatory framework conducive to private investment in this sector. In other sectors, particularly those related to infrastructure, the sector level policy and institutional frameworks are not yet sufficiently supportive of private investment. In power, private investment has been deterred by low tariffs and uncertainty over future financial returns--indicative of the magnitude of the problem, the financial losses of state-owned electricity companies have been at around 1.2-1.4 percent of GDP over the last few years. In roads, an institutional framework enabling the private sector to acquire land and collect tolls is not yet in place. In urban areas where there is an urgent need to invest in infrastructure, existing institutional arrangements effectively  - xi - exclude private investment. In hydrocarbons, in spite of several rounds of offering since June 1991 of offshore and onshore areas for exploration, few contracts have been signed. 30. The response of private investment to the liberalized policy framework will depend on the speed with which appropriate sector-level policy and institutional frameworks are established and complementary public investment is increased. In the short run, the recovery of private investment requires decisive steps to provide a wolicy and regulatory framework conducive to private investment in such sectors as telecommunications and hydrocarbons, where there is an urgent need to expand capacity and strong private sector interest. In these sectors, private investment could reach several points of GDP in a relatively short period of time, anid contribute to a rapid and sustainable recovery. There is also a need to improve the investment climate irn agriculture and agro-business. Private investment in agriculture has historically accounted for as much as 15 percent of total private investment, and its reviva, could also contribute to a sustainable recovery. In the medium term, the expansion of private investment will require addressing fundamental issues such as de facto barriers to entry in sectors now open to private investment such as power, urban infrastructure and roads; insufficient public investment in infrastructure; and the size of the public sector deficit (central government, states, and public enterprises). Unless the public sector deficit is reduced significantly, India will remain vulnerable to macroeconomic instability and high real interest rates, and private investment will suffer. 31. ManaFing Capital Inflows. In response to the partial opening of the capital account in 1992 (para. 15) foreign investment increased to US$4.7 billion in 1993-94. Of this, only about US$0.6 billion consists of direct investment; about US$1.6 billion consists of investment in equity shares by foreign institutional investors permitted to enter India's capital markets by a policy change made in September 1992; and about US$2.5 billion consists of overseas issues of equity shares (US$1.5 billion) and debentures (US$1 billion). The debentures are convertible, and carry interest rates of about 3-4 percent. In theory, large capital inflows should enable India to increase its investment rate, thus expanding the country's production base and increasing its growth rate. In practice, these large inflows are not an unmitigated blessing. They pose complex choices to the authorities, and threaten the competitiveness of the real exchange rate, maintenance of which is essential for India to continue expanding its export base (from which the capital inflows will be serviced) and to reap the full benefits of the reform program the country has been implementing since Julv 1991. 32. As indicated in a recent IMF paper (S. Schadler et al., Recent Experiences with Surges in Capital Inflows, IMF, December 1993), in the face of large and persistent inflows, a tightening of fiscal policy can help contain inflation and avoid a real appreciation of the exchange rate. However, fiscal adjustment has not figured significantly as a response in most countries that have recently experienced a surge in capital inflows. Although fiscal positions generally improved following the surge in inflows, this was less a response to the inflows than a continuation of the fiscal consolidation that in part attracted the inflows in the first place. Fiscal consolidation has nonetheless helped prevent a real exchange rate appreciation.  xii - 33. In India, capital inflows have surged at a time when not only the fiscal deficit is still relatively high, but also, reflecting low domestic investment, the current account of the balance of payments is virtually in balance. C.-nital inflows have thus placed the nominal exchange rate under pressure to appreciate. The RBI has thus far held the exchange rate constant in nominal terms by purchasing all the excess supply of foreign exchange at that rate. This has caused rapid reserve accumulation and expansion of base money, which has created inflationary pressure and has meant a real appreciation of the rupee--which would be detrimental to continued strong export performance. This highlights that seeking to maintain a competitive real exchange rate by merely targeting the nominal exchange rate could be an elusive goal in the presence of continued strong capital inflows. 34. In essence, widening the current account deficit of the balance of payments or accumulating foreign exchange reserves are the two avenues through which India could respond to capital inflows. Whether the current account is widened through a reduction in domestic savings (i.e. an increase in domestic consumption) or through an increase in domestic investment, however, is of critical importance for the iong run growth of the economy and its future capacity to service the inflows. Typically, countries that entered a capital inflow episode close to full capacity utilization and rapidly growing investment, have been able to translate capital inflows into higher investment and higher growth, with no appreciation of the real exchange rate. In countries where capacity utilization was low and investment sluggish, the widening of the current account deficit has been accompanied by increased domestic consumption, exchange rate appreciation, and an erosion of the export base. Accumulation of foreign exchange reserves can be costly. As highlighted above, unless the monetization of the inflows is sterilized, there is a loss of control over the money base, inflation and appreciation of the real exchange rate. Sterilized intervention, nowever, implies rising domestic real interest rates and can be the source of large losses to the central bank. 35. The challenge to the Indian authorities is to formulate a policy response which protects the competitiveness of the real exchange rate and translates the unexpected surge in capital inflows into higher investmenit. In the medium and long-term, as the fiscal deficit is reduced, and real interest rates decline, economy-wide reforms will enable investment to recover. The problem should then become more manageable--the current account deficit should widen and, with the reduction in the fiscal deficit, the sterilization capaciti of the RBI will also increase. in the more immediate future, however, consistent with the lessons of experiences from other countries, it could be costly to seek to absorb large voliimes of potentially volatile capital inflows not associated with investments while the fiscal deficit is still at a relat:>ely high level, import restrictions remain significant, and the banking system is being restruc. 1. Under these circumstances, the most prudent policy course would be to utilize market-basea instruments to slow capital inflows to a level that the economy can absorb without undermining macroeconomic stability and external confidence. Guidelines were introduced in May 1994 restricting issues of equity abroad to one per year per firm for frms with investnent plans sufricient to absorb the financial resources mobilized abroad. This step should help reduce the volume of capital inflows and the pace of foreign exchange reserve accumulation, but further actions may become necessary. In the medium to long-term, the absorptive capacity for capital inflows will be  - xiii - determined by the magnitude and quality of fiscal adjustment, and the pace of structural reforms, which in turn will impact on the speed of recovery of investment and the rate of growth. F. External Financing Requirements 36. The remarkable improvement in India's external accounts in 1993-94 has eliminated the need for fast-disbursing assistance much faster than expected, and no additional fast-disbursing assistance needs are envisaged for the foreseeable future. However, continued access to high quality long-term development assistance will remain critical for India to be successful in its reform program, set the economy on a higher growth path and alleviate poverty. Public investments in a number of strategic sectors have been lagging--notably in the power, transport, agriculture and social sectors. While the private sector has indicated interest in investing in some of these sectors, public sector investment will continue to play an important role for some time and official development assistance will remain vital to sustaining investment in these key areas of the economy. Li this context, the members of the Consortium should aim for highest possible quality assistance both as regards the terms and the deployment of their assistance. Support for the government's structural reform program for the social dimensions of the reforms and for enviromnentally sustainable development should in the view of the Bank be the guiding considerations in the deployment of the available assistance. The response of an economy, particularly that of the balance of payments, to a comprehensive liberalization program of the kind now being implemented in India is evidently very difficult to predict. The members of the Consortium should thus also stand ready to resume fast disbursement assistance should the need arise. G. AfanaRing India's Environment--Selected Aspects 37. The short-to-medium term policy initiatives outlined above, complemented by progress on basic mediun-to-long term sectoral development issues in population, health, education, agriculture and infrastructure, h.old forth the promise of sustained relatively rapid and equitable per capita economic growth. With this growth, superimposed upon a rapidly growing and urbanizing population, inevitably will come more potential pressure on India's air, water, and land resources. 38. The Government has iong recognized the importance of environmental protection. India's formal, national efforts to manage its environment go back to the early 1970s, when former Prime Minister Indira Gandhi established the National Committee of Environmental Planning. Today, the Ministry of Environment and Forests (MoEF--the institutional descendent of this committee) has wide ranging, rapidly expanding responsibilities as the apex Government body responsible for the enviromnent. It concentrates on the zonservation of forests, wildlife and biodiversity (which account for about 70 percent of total MoEF spending), and environmental pollution control (about 27 percent of MoEF spending). Its spending (plan and non-plan) has grown at almost 16 percent annually in nominal terms since 1986/87. By way of comparison, GOI total developmental spending increased at an annual nominal rate of only about 5.4 percent over this same period.  - xiv - 39. The MoEF is backed up at the state level by state departments of environment and state pollution control boards. Broadly. under the acts governing the activities of these agencies, the central government is responsible for making policy, setting national standards, and oversight of states activities; state governments are the front-line implementors and regulators. Over the years, working together, the agencies have erected a comprehensive regulatory and stratcgic framework for control of pollution and conservation of forests, wildlife, and biodiversity, and implemented this framework--despite some severe institutional shortcomings--with increasing effectiveness. In response, some dimensions of environmental quality seem to be improving (e.g., biochemical oxygen demand in India's rivers, area of forest cover). 40. This progress notwithstanding, the challenge of developing India's economy in an environmentally sustainable manner remains formidable. Certain environmental pollutants (e.g., suspended particulate matter in the air, and coliforn organisms in the water) have reached levels that are well in excess of levels judged to be healthful. While there are no clear trends in the levels of these pollutants, others (e.g., nitrogen dioxide, lead) seem to be becoming more serious. Health data broadly corroborate this picture: roughly 30 percent of India's loss of Disease Adjusted Life Years (DALYs--as reported in the 1993 World Development Report) are attributed to environmental causes. The corresponding figure for China is about 25 percent; in the developed world, the figure is about 10 percent. Trends with respect to India's ecosystems and biodiversity are less clear cut, but experts agree that forests and other ecosystems are in danger. 41. The Government will thus have to accomplish even more in the future than it has in the past, and do so in a tight fiscal environment in which it will not be possible to fnance continued growth of environmental budgets from ordinary budget resources at anything like the rates of growth achieved over the last several years. Clear priorities and efficient and effective strategies will be essential to maximize the sustainable development impact of the budget resources available. One of the main priorities will be to strengthen the institutional capacity and processes to improve compliance with the existing regulations and safeguards. 42. India has taken the first steps in this direction with the completion in late 1993 of an Environmental Action Programme (EAP). The EAP sets out seven broad priority areas and a set of corresponding programs. The Government has made it clear that it regards the EAP as only a first step: priorities, programs and strategies will evolve based on experience and continuing analysis, discussion, and debate in India. Several questions will undoubtedly be raised repeatedly in this process: (i) Is India addressing the right environmcntal problems? (ii) Are these problems being addressed efficiently? (iii) Is the inbtitutional framework adequate? and finally (iv) Is India doing enough to achieve environmentally sustainable development? 43. These are difficult questions. There is no one "right' answer to any of them. There are, however, some working hypotheses that emerge from an examination of the data and information available. These are discussed briefly in the following paragraphs. 44. Paioity Problems. Among the priorities identified in the EAP, three areas appear to merit special emphasis.  - xv - 45. Many of India's environmental problems can be traced to distortions in economic policies. Subsidized consumption of power, fertilizers, irrigation water, diesel fuel, and water encourage wasteful consumption of these resources and thereby contribute to etnvironmental degradation. Subsidies for livestock development, agricultural development, policies with respect to development of the road system, and policies intended to promote the development of forest-based industries may inadvertently be encouraging the degradation of foi-ests and protected areas, as has happened in other countries. Relorms to eliminate these distortions would yield two kinds of benefits--reduced economic waste and reduced enviromnental damage-- and thus merit very high priority. 46. First, indicative calculations suggest that three environmental pollution problems should receive high priority on the grounds that their "solution" could yield substantial health benefits at relatively low incremental costs. Reducing suspended particulate air pollution and improving basic water and sanitation services would large net health benefits and thus merit priority attention. Given the potential for serious harm to health from hazardous and toxic pollutants, there is an urgent need to know more about the nature and quantities of materials being generated today and the ways in which they are collected transported, and disposed. 47. The calculus of priorities for conservation of forests, biodiversity, and wildlife is inherently less clear cut. The task is doubly difficult in India today because of the scarcity of hard, quantitative data and information about what is happening to India's ecosystems and why. One clear priority is thus the development of more and better information and data. Notwithstanding the lack of data, sensible clear conservation priorities have been laid out in a plan for a wildlife protected area, and in the identification of protected areas. High priority should be accorded to carrying forward the implementation of these issues. 48. Efficient Approaches. One of the most interesting and exciting recent developments on the Indian environmental scene is the use of ezonomic incentives and participatory approaches to encourage conservation of forests, wildlife, and biodiversity. In contrast to its conservation strategies, India's present pollution control strategy basically combines a big stick (standards and regulations enforced under threat of criminal penalties) with a small carrot (tax breaks on the purchase of pollution control equipment). Despite the progress made to date in containing air and water pollution, some modification of the present strategy to shift some of the burden of securing pollution load reductions to economic incentives (e.g., pollution charges, pollution trading schemes) could be both more effective and efficient than the present approach. 49. Institutions. India's institutional framework for environmental pollution control is well- developed. The major challenges in this area are strengthening monitoring and enforcement. Some legislative guidance on objectives (e.g., how should the Government weigh health and other considerations in setting standards; what role should economic considerations play in standard setting?) and instruments (e.g., what role should pollution charges and pollution trading play in India's pollution control strategy?) would perhaps be useful. 50. Some additional legislation is needed (and under development) in the conservation area to provide a firmer institutional foundation for new conservation approaches like joint forest  - xvi - management and ecodevelopment. The law may also need to be made more flexible in tenns of the kinds of land use arrangements it will allow on forest lands and protected areas. 51. There are also priority needs with respect to toning up front line envirounental management agencies. State pollution control agencies are short of staff trained in enviromentai engineering and in proper monitoring and enforcement procedures. There are also severe equipment shortages. On the conservation side, training and reorganization are needed to implement the new approaches now being used to manage forests and protected areas. 52. Is It Enoug-h . The rapid growth of expenditure and the impressive achievements to date notwithstanding, the general picture that emerges with respect to both pollution control and conservation is that the resources currently available fall well short of what would be required to implement fully the provisions of India's curreli laws and policies. The prospects for continuing rapid growth of budgets for the environment are not bright. Environment will have to compete with other underfunded high priority sectors like education and health in the context of continuing fiscal adjustment. 53. India will thus have to leverage the budgetary resources it can commit far more highly in the future than it has in the past. Strategies employing pollution charges and/or pollution trading could in addition to encouraging effective and efficient pollution prevention and control, also mobilize resources for enhanced monitoring and enforcement or investment in pollution control programs. Imaginative incentive-based participatory approaches to conservation of natural resources such as joint forest management and ecodevelopment now being pioneered in India can, in addition to providing more effective protection, generate income, employment, and budgetary revenue. The international community must also help. All of these sources will have to be tapped.  CHAPTER 1: RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS A. Introduction 1.1 In July 1991, a new government started to liberalize the economy with a reform program focused on the investment regime, trade policies, the financial sector, taxation, and public enterprises. The reforms' maior objectives were to reduce the capital intensity of India's growth process, lessen its reliance on the unsustainable expansion of the public sector, and thus translate the country's relatively high investment rate into high and sustainable growth of output and employment. Compounding the difficulties inherent in any liberalization process, the govermnent also faced serious fiscal and external imbalances which had generated double-digit inflation and put the country on the verge of defaulting on its external debt obligations. 1.2 Over the last three years, notwithstanding a sharp increase of the fiscal deficit in 1993- 94, the government has made considerable progress in reducing non-interest expenditures. It has been remarkably successful at improving the country's current and capital external accounts. And it has introduced structural reforms which have significantly liberalized the economy. Carried to their logical conclusion, these reforms could enable India to grow at the rates experienced by its successful East Asian neighbors. Transforming this possibility into reality requires intensified efforts to strengthen public finances, improve infrastructure, and enable private investment to flow into key areas of the economy. In turn, this entails broadening the process of reform, which has thus far been dominated by a few central ministries (Finance, Commerce, Industry), to sectoral ministries public enterprises, and state governments. 1.3 Chapter 1 reviews the achievements of three years of stabilization, including fiscal adjustment at the level of the states. Next, it examines the economy's response and prospects, including the response and prospects of private investment. Finally it assesses India's medium- term external financing requirements. Chapter 2 reviews progress in reforming the economy over the last three years, and identifies the shorn and medium term policy issues facing the government. Other irnportant parts of the govermment medium term development agenda, such as initiatives taken over the last three years to accelerate the development of India's human resources, particularly those of the poor, have been discussed in last year's World Bank economic report on India. Steps taken to address India's env.ronmental problems are discussed in Chapter 3. B. Stabilizing the Economy Introduction 1.4 In July 1991, the authorities were faced with a central govermment fiscal deficit which had reached 8.4 percent of GDP in 1990-91 (9.8 percent of GDP for the central and states governments combined). If uncorrected, it would have exceeded 10 percent of GDP in 1991-92. India's historically low inflation had exceeded 10 percent in November 1990 (measuin d by the wholesale price index, point-to-point) and continued to rise, peaking at 17 percent it, August 1991. At US$10 billion in 1990-91 (3.5 percent of GDP), the current account deficit of the balance of payments was unsustainable. Notwithstanding significant assistance from  - 2 - multilaterals, particularly the IMF, and bilaterals, particularly Japan, foreign reserves had declined to US$1 billion in June 1991, two weeks of imports; India was on the verge of defaulting on its external debt obligations. DemAnd Mana ement 1.5 _pediure Switching and Contraction of Demand. In July 1991, the governnment's highest short-term priority was to stabilize the economy through expenditure switching and contraction of aggregate demand. The rupee was devalued in July 1991, and floated in March 1992. It fell from Rs 21/US$ in June 1991 to Rs 311US$ in March 1992, and has remained at around this level since then. To stabilize demand, the govermnent tightened monetary policies and made it a key objective to reduce the central goverunent fiscal deficit. The June 1993 Ministry of Finance's Discussion Paper on the overall objectives of the stabilization and reform program notes that "Rising fiscal deficits [in the 1980s] had created many problems. They had led to high levels of borrowing by the Government from the Reserve Bank, with an expansionary impact on money supply leading directly to high rates of inflation. High fiscal deficits contributed directly to the large current account deficits in the balance of payments and thus aggravated the problem of external indebtedness. Large fiscal deficit also, pre-empted a significant proportion of the savings of society to support the Budget, with a consequent scarcity of funds for productive investment. This was reflected in very high interest rates facing the commercial sector, which discouraged new investment and also reduced our international competitiveness. " 1.6 The government succeeded in reducing the central government's fiscal deficit in the first two years of the program, from 8.4 percent of GDP in 1990-91 to 6.0 percent of GDP in 1991- 92, and 5.7 percent of GDP in 1992-93 (Table 1.1). Broad money growth was maintained at 11-13 percent in 1991-92 and 1992-93, against a nominal GDP growth of 15-16 percent. Much of this progress was lost in 1993-94, however. The fiscal deficit escalated to an estimated 7.3 percent of GDP, against a target of 4.7 percent of GDP, as a result of both revenue shortfalls (40 percent of the deviation) and expenditure overruns (60 percent). Base money growth rose to annual 25 percent as a consequence of the monetization of capital inflows (Table 1.14) which were particularly strong in the first few months of 1994. To contain the inflationary impact of this increase in liquidity, the RBI increased reserve requirements by I percentage point in May 1994, but the build-up of primary liquidity is likely to continue putting pressure on prices in the near future. 1.7 Fiscal efforts at the level of the central government have not been replicated by the states and public enterprises. As discussed in section E of this chapter, the fiscal deficit of the states has remained relatively constant at 3 percent of GDP over the last three years. Similarly, profits of profit-making public enterprises have not improved, and the losses of loss-making public enterprises have not declined (para 2.21). In the next phase of reform, fiscal adjustment at the level of the central government would need to be complemented by an improvement in the finances of the states and public enterprises.  3- Table 1.1: Central Government Finaces, 19*9S0 (Rs bfllion and pereMage of GDP) Rs billion Perent o GDP 9091 91-92 9243 9S94 93%94 94-95 9I91 91-92 92.93 93-94 934 94.95 .,___________ , , - ) -RE) (BE) ,(B) ME) (BE A. Revenue 550 660 741 842 762 861 10.4 10.7 10.5 10.6 9.6 9.6 Tax Revenue 430 -501 540 627 545 627 9.1 8.1 7.7 7.9 6.9 7.0 Corprte 53 79 89 105 105 125 1.0 1.3 1.3 1.3 1.3 1.4 income 54 67 79 95 95 109 1.0 11 1.1 1.2 1.2 1.2 Excises 245 281 308 338 318 367 4.6 4.6 4.4 4.2 4.0 4.1 Customs 206 223 238 277 225 252 3.9 3.6 3.4 3.5 2.8 2.8 Others 17 24 32 34 25 18 0.3 0.4 0.5 0.4 0.3 0.2 Less: States'share 146 173 206 221 223 244 2.7 2.8 2.9 2.8 2.8 2.7 Non-tax revenue 120 160 201 215 217 233 2.3 2.6 2.8 2.7 2.7 2.6 (Interest eceipta) 87 109 t25 145 145 160 1.6 1.8 1.8 1.8 1.8 1.8 R. Revnue epndire 735 823 927 1,018 1,102 1,188 13.8 13.4 13.1 12.8 13.8 13.2 bIterest payments 215 266 310 380 375 460 4.0 4.3 4.4 4.8 4.7 5.1 Subsidies 122 123 121 84 124 95 2.3 2.0 1.7 1.1 1.6 1.1 Pood 25 29 28 30 52 40 0.5 0.5 0.4 0.4 0.7 0.4 Ferilizer 44 48 58 35 44 40 0.8 0.8 0.8 0.4 0.6 0.4 Others 53 46 35 19 28 15 1.0 0.7 0.5 0.3 0.3 0.3 Defense 109 114 124 137 149 162 2.0 1.9 1.8 1.7 1.9 1.8 Grants to states 140 t67 179 196 206 196 2.6 2.7 2.5 2.4 2.6 2.2 Wages and salares 104 115 130 141 142 155 2.0 1.9 1.8 1.8 1.8 1.7 Other 45 38 63 80 106 120 0.8 0.6 0.9 1.0 1.3 1.3 C. Capital expenditure 121 115 128 128 132 141 2.3 1.9 1.8 1.6 1.7 1.6 Deense 46 49 51 55 66 68 0.9 0.8 0.7 0.7. 0.8 0.8 Economic Services 67 57 66 58 53 59 1.3 (G.9 0.9 0.7 0.7 0.7 Others 9 10 II 15 14 14 0.1 0.2 0.2 0.2 0.2 0.1 D. Gross loans 197 179 168 167 204 187 3.7 2.9 2.4 2.1 2.6 2.1 to states 136 123 121 118 144 138 2.5 2.0 1.8 1.5 1.8 1.6 to PEs 36 35 30 36 49 41 0.7 0.5 0.4 0.5 0.6 0.5 Oftes 25 21 17 13 tl a 0.5 0.4 0.2 0.1 0.1 0.1 E. Repayment of loans 57 60 64 67 67 67 1.1 1.0 0.9 0.8 0.8 0.7 P. Net leding (D-E) 139 t19 106 100 138 121 2.6 1.9 1.5 1.3 1.7 1.3 G. Disinvsent in PBs 0 30 20 35 25 40 0.0 0.5 0.3 0.4 0.3 0.4 Flscal Ddlit (A-BC-F+G) 447 367 400 370 586 549 8.4 6.0 5.7 4.6 7.3 6.0 Memo iems TotalExpendU (B+C+D) 1,053 1,117 1,223 1,313 1,438 1,516 19.8 18.1 17.3 16.5 18.0 16.8 Prm Deidt' 232 101 90 -10 211 89 4.4 1.6 1.3 -0.1 2.6 0.9 Non-Iterest sp tAn 838 851 913 933 1,063 1.056 15.8 13.8 12.9 11.8 13.3 11.7 BE = budget estimates; RE - revised estimates. Revenue expenoinire is fte budget teninology for curnmt expenditure. 1/F Fis defict mnus intest payments. A zero primary deficit indicaes that the govenuent debt rermains constnt in relation to GDP if the real ierest rate is equal to real GDP growth ana that is dedining if the real interest rate is lower than real GDP growth. If the rea interest rate on govenmmentdebt is smaller than real GDP grwth, the debt to GDP ratio can decline *ven if the prmaty deficit is positive. 21 B+C+Dlinterest. Sore Goverme of dia. Budget documents. 1.8 The Pattern of Central Governnent FTshd A stment. In the firt two years of the program revenues s.emained relatively constant at around 10.5 percent of GDP. The 2.7 percentage point reduction in the fiscal deficit was achieved entirely through expenditure cuts, mostly of subsidies (0.6 percentage points of GDP), defense (0.4), loans to states (0.7), loans to public enterprises and other entities (0.6), and non-defense capital expenditure (0.3). According to the preliminary fiscal accounts for 1993-94 published at the time of the budget,  -4 - the 2.6 percentage points of GDP slippage in 1993-94 is the result of a I percentage point of GDP tax revenue shortfall due to stagnant industrial output, lower than expected imports and thus lower tariff revenues. Expenditure overruns (on subsidies, defense, and loans to states and public enterprises) account for the remaining 1.6 percentage points of the slippage (Table 1.1). In spite of the slippage in 1993-94, expenditure on subsidies, defense, and loans to states and public enterprises remained below their corresponding GDP shares in 19' - -91. In fact, the central government has reduced non-interest expenditure by 2.5 percentage points of GDP between 1990-91 and 1993-94 and the primary deficit by 2.8 percent of GDP (Table 1.1). It is important to note that the Rs 25 billion disinvestment expected to take place in March 1994 (Table 1.1) has in fact taken place in April. The govermment expects non-interest expenditure underruns of a similar amount to have offset this decline in revenue but precisely in which expenditure categories underruns have taken place will only be known in September 1994 when the fiscal accounts for 1993-94 will be closed. This would suggest that non-interest expenditure in 1993-94 has in fact been 13 percent of GDP (instead of the 13.3 percent indicated in Table 1.1), that the contraction of non-interest fiscal spending has been even more significant than suggested in Table 1.1, and that increases in revenues will need to play a larger role in fiscal retrenchments in the future because the scope for significant fiurther expenditure reductions is limited. 1.9 T h e reduction in the Table 1.2: Recent Evoludon of the Puie Deficit, 1989-94 cost of subsidies (rcentof ODP) was achieved through the 1989-90 1990.91 1991-92 1992-93 1993-94" elimination of an export subsidy in OvnU Dficit 7.8 8.4 6.0 5.7 7.3 July 1991, and oross PrimM Deficit v 4.0 4.4 1. 1.3 2.6 several rounds of 2. General Governnet increases in the Oveall Deficit 9.3 9.8 7.2 7.3 8.7 subsidized prices of Gross Ptmary Deficit2 4.8 5.1 2.2 2.0 3.2 fertilizer and 3. Nor-Finam2ialPublicSector commodities OveralDefit 11.1 11.S 8.7 8.7 n.a. (mostly rice, wheat 4. MRmIem: RBI Financing to General and kerosene) sold IFCIovmn1t (Net) 3.1 2.9 0.8 0.6 0.7 through the Public Dis* *tributi Notes: . Basd on budget esmats for the sates. i s t r i b u t 10 n v Ove deficit excludinggross u e paymen. System. In the case of rice, for sju. Budget documR andsaff esimas. example, the subsidized price was Rs 3.5/kg in June 1991; the Government raised it to Rs 4.4/kg in December 1991, Rs 5/kg in January 1993, and Rs 6.2/kg in February 1994-a cumulative 77 percent increase. The February 1994 increase, however, was introduced with a significant delay; this was the main reason for expenditure overrun on subsidies in 1993-94. Similar developments have taken place  in the case of wheat and urea. The decline in lending to the states has taken place mainly through reduction in relation to GDP of Small Savings collections (savings accounts managed by the postal service), a consequence of reductions in tax incentives on such instruments. While the decline is relatively modest, it has created some financing constraints for the states (para. 1.51). The decline of budgetary assistance to public enterprises has been consistent with the objective of transforming them into commercially viable concems, but has contributed to their financial difficulties. flscal Sustainabili 1.10 Unless future fiscal performance shows it to Table 1.3: Evolution of the blic Debt Stck, 1990-94 have been an aberration, (percent of GDP at end of period) the worsened fiscal performance in 1993-94 90-91 91-92 92-93 93-941 could undermine the L, Domestic Debt 21 68.9 67.0 n.a n.a. credibility of the fiscal ~~General Governnent 59.5 57.8 56.4 58.0 credibility of the fiscal Center 53.4 51.6 50.4 51.4 adjustment process. At 66 states" 6.1 6.2 6.0 6.6 percent of GDP by end Non-funancial Public Enterpri' s 9.4 9.2 n.a. n.a. 1993-94, the central H. Extemal Debte 16.1 22.0 n.a. n.a. government debt (90 General Goverrnent 11.6 16.9 16.2 14.7 percent of the consolidated Non-funal Public Enterprises 4.5 5.1 n.a. n.a. central and states in., Total (1+11) 85.0 89.0 n.a. n.a. General Government 71.1 74.7 72.6 72.7 governments debt) is Cenur 65.0 68.5 66.6 66.1 relatively high. Interest States 6.1 6.2 6.0 6.6 payments already claim Not-fiancial Public Enterpnses 13.9 14.3 n.a. n.a. over half of central Memo Item: .GeneralOiovemmentdebt heldbyRBI(nea) 16.7 15.3 13.9 13.1 government fiscal Cener 16.4 15.0 13.7 12.9 revenues. The financial States 0O4 0.3 0.3 0.1 sector reforms underway Notes: uProjected. and the reduction in central Gross of debt hdd by the RBI. 3' Excluding Stats' debt to Center. government recourse to 4Excluding IM debt. Converted at the end of period exchange rate. RBI credit (paras. 2.13- Extrna borrowins by the states are zero. 2.15) will further increase Sme RB! an stff estmats. average interest rates on the government debt and compound the problem. Taking into account these higher average real interest rates, stabilizing the central government debt in relation to GDP at its March 1994 level-a minimum objeztive for sound public finances- -requires the primary deficit to be reduced by 1-2 percent of GDIP beyond what is envisaged for 1994-95. Unless the 1994-95 fiscal deficit target of 6 percent of GDP is met (a difficult objective since the 1994-95 fiscal deficit target is based on the assumption of a recovery, paras. 1.40 and 1.45), and decisive steps are taken to reduce it further in 1995-96, the central govermnent fiscal deficit could endanger India's economic prospects. Strong improvement in  -6 - the finances of the central government need to be accompanied by improvement in the finances of the states and public enterprises. 1.11 Historically, the central government has financed its deficit from four sources: (i) the RBI, through the placement of so-called ad hoc Treasury bills at a fixed interest rates of 4.6 percent; (ii) the banking system, which must hold a fixed proportion of its deposits in "dated" governent securities (that is medium and long term securities) at below market rates as part of its Statutory Liquidity Requirements (SLR, see para. 2.12); (iii) the private sector, through instruments such as Small Savings accounts and Provident Funds; and (iv) abroad. The first two of these sources used to provide low cost (forced) financing, and made it possible to keep t"' overall explicit costs of financing the central government deficit (and thus over time the deficit itself) relatively low. 1.12 Such low cost finance is ceasing to be available following: (i) the government's decision to phase out forced SLR borrowings from banks at below market rates; and (ii) the 1994-95 Budget announcement of a rapid phasing out of the recourse to RBI deficit financing (para. 2.14). The government has already shifted to a system of auction for new issues of dated securities on which it has been paying market related interest rates (Table 1.4). Indicative of the attractiveness of new dated securities, commercial banks are holding dated securities beyond the SLR mandated requirement. In addition, through the gradual introduction of regular auctions of Treasury Bills (para. 1.30), the govermnent has gradually reduced its recourse to RBI fmancing (Table 1.2). 1 .13 These changes imply that Table 1.4: Interest Rates on Central Govemment Debt, 1989-94 in the near future (percent per annum) the central government's 89-90 90-91 91-92 92-93 93-94 marginal cost of Average Interest Rate on: borrowing Daed Securities 9.7 10.2 10.4 10.2 10.6 bo r r ow l n g SmallSavings 9.3 9.7 11.4 11.3 13.0 domestically will be ProvidentFunds 12.9 12.3 12.4 13.4 12.4 dictated b y Extenal Debt 3.5 3.5 4.4 4.0 4.0 financial markets. They also imply Memo Items: Interest rat on: that the central New issues of dated securities" 11.0 11.0 11.5 12.4 13.1 government will Inflation (GDP deflator) 8.6 10.7 14.7 9.5 n.a forgo revenues Notes: '8 Average of mininum arv maximum rate on new market issues. from the implicit Sore Ecnomic Suvey. RB and stff esmates. taxation of fmancial intermediaries, as well as seignorage revenues collected by the RBI--that used to be implicitly transferred to the government through low interest paid on RBI-held debt. Thus, as indicated in para. 1.10, the average rate on the central government debt will gradually approach the marginal rate. While estimates of precisely  -7- when this will occur are not available, the difference between the average and the marginal interest rate on the central govermnent debt is already small and declining (Table 1.4) and this has important consequences for the central government sustainable fiscal stance. 1.14 Under reasonable assumptio1-i on the speed of future financial sector reform and the future pattem of fiscal adjustment (a fiscal adjustment biased against public investment reduces long-tern growth and thus increases the debt to GDP ratio), stabilizing the central government debt to GDP ratio at its end 1993-94 level requires a primary deficit between 0 and negative 1. Thus, as indicated in para. 1.10, the primary deficit needs to be reduced by 1-2 percent of GDP beyond what is envisaged for 1994-95. To the extent the adjustment is delayed, the required correction increases. From a short run perspective, the extent of the correction is somewhat overstated by the assumption that interest payments on the outstanding stock of domestic debt are made at the marginal interest rate, rather than at the currenttly lower average rates. However, it does highlight the narrow limits within which the central government is operating and the risks of falling into a domestic debt trap. To avoid this, and establ-sh the credibility of fiscal policies, it would be essential to reach a primary surplus of 1 percent of GDP in the next two years. C. The Economy's Res 3nse Introduction 1.15 The response of the economy t o t h e Table 1.5: GrowthPerfonmane, 1981-94 stabilization and reform (Peretage) measures implementedt since July 1991 has been 8t-so 9-91 9-9 92-93 93-94 generally positive, but GDP at Factor Cost 5.5 5.2 1.8 4.0 3.8 macroeconomic stresses Agriculture 3.4 4.8 -3.4 5.0 2.3 brought about by the Industry 6.9 6.9 1.0 2.2 3.3 reform program pose new Mming & Quarrying 7.4 4.9 9.3 3.8 3.4 Mamnfacturing 7.2 7.5 -1.5 2.0 2.5 challenges for policy. Registered 8.0 7.4 0.6 1.1 I.a. Growth recovered from 2 Unregistered 6.1 7.5 -4.8 3.7 n.a. in 199192 to ~~~Electricity 8.9 6.9 8.0 6.5 8.1 percent in 1991-92 to Couction 4.4 4.9 5.3 0.1 3.8 around 4 percent in the last Services 6.6 4.2 6.7 4.5 5.2 two years (Table 1.5). Soure: Cetarl Statstical Organization, National Accounts Statstics. Quick Estimates Industrial production and for 1992-93, aid Advanced Estimates for 1993-94. investment have been slower to recover from the deflationary effects of the initial stabilization measures (Tables 1.6 and 1.7). After declining to negative 2 percent in 1991-92, manufacturing growth recovered to a modest 2 percent in 1992-93 and 1993-94. While this deceleration is modest compared to that experienced in other countries' stabilization and reform experiences, the authorities have been justifiably concerned by declining investment rates. The improvement in India's external accounts, both current and  capital, has exceeded the most optimistic forecasts. With exports girowing at 20 percent in 1993- 94, imports growing at only 6 percent (partly the result of slow growth in manufacturing), and an improvement in the service account, the current account deficit declined to US$0.8 billion in 1993-94 (0.3 percent of GDP), from U5$10 billion in 1990-91 (3.5 percent of GDP). At US$4.7 billion, foreign investment (largely portfolio investment) surged to unprecedented high levels. As a result, reserves increased from less than US$1 billion in June 1991 to US$15 billion by end-March 1994. The monetization of reserves, however, has led to a sharp c-spansion in base money--25 percent in March 1994 in relation to March 1993. Together with significant increases in administered prices, this has contributed to inflation. After declining from a peak of 17 percent in August 1991 to around 7 percent in mid-1993, inflatiun has increased again, exceeding 10 percent in early April 1994. As a result, the real exchange rate has appreciated. Table 1.6 Indwrial Growth by &idustry of Use, 1981-94 (Annual Percent Increase) April - October Weight 81-91 90.91 91-92 92-93 92-93 93-94 Index of Industrial Producdon 100.0 7.9 8.2 0.1 2.4 3.8 2.2 Basic Industis 39.4 7.7 3.8 6.2 3.5 3.7 2.9 Capital Goods 16.4 11.4 17.4 -12.8 2.8 9.0 -8.8 I nteaniediats 20.5 6.6 6.0 -0.7 2.8 4.0 10.4 Consumer Goods 23.7 6.5 10.4 -0.3 0.0 0.0 1.4 Duables 2.6 13.8 14.8 -12.5 -0.7 -3.8 14.3 Non-Durables 21.1 5.2 9.4 1.2 0.1 0.8 -1.6 NMo: Basic industries include capital intesive industies such as steel, ferdlizer, cement and electricity. ! : Cental Statistica Organizaton - National Accunts Statistics and Economic Survey, various tssues. in} Investmnent 1.16 The central government has taken steps to increase investment by public eilterprises and the states--total budgetary and non-budgetary resources were maintained at 7 percent of GDP in 1991-92 and 1992-93, and increased to 8 percent of GDP in 1993-94 (Table 2.6). However, these additional resources have not been translated into actual investment. National accounts statistics indicate that growth of public investment declined from 4-5 percent during the 1980s and 1990-91, to 3 percent in 1991-92, and negative 5 percent in 1992-93, the last year for which data are available (Table 1.7); this decline has likely continued in 1993-94. Growth of private investment by households (in housing, agriculture, and unregistered and registered but unincorporated manufacturing firms) declined from 9 percent in the 1980s and 11 percent in 1990-91 to negative 21 percent in 1991-92, before rising to a modest 3 percent in 1992-93. Investnent by the private corporate sector remained robust through 1992-93, but the sharp decline in the production of the capital goods industry in the first half of 1993-94 (Tabie 1.6) suggests that this trend may have reversed itself in 1993-94. In addition, imports of capital  9- goods have declined from US$5.8 billion in 1990-91 to around US$4.2-4.5 billion in 1991-92 and 1992-93 (the last year for which data are available). Together with a sharp decline in the current account deficit in 1993-94, (hence in the savings-investment imbalance), these developments are indicative of a sharp decline of investment in the economy. Table 1.7: Investment by Type of Institution, 1981-93 (Percent of GDi at market prices) 1981-1991 1990-91 1991-92 1992-93 ra.,Ss Capit Formation 24.0 (6.7) 26.5 (12.3) 24.0 (-15.6) 25.0 (19.8) Owss Fixed Capital Formation 21.0(6.9) 23.1 (10.2) 22.0 (-5.9) 21.3 (1.7) Public Sector 10.1 (5.3) 9.4 (3.8) 9.5 (2.8) 8.8 (4.8) Private Corporate Sector 3.6 (7.0) 3.8 (22.9) 4.2 (9.7) 4.5 (11.8) Household Sector 7.3 (9.1) 9.9 (11.4) 8.3 (-21.4) 8.v (3.3) Chamge in Stocks 3.0 3.4 2.0 3.7 Note: Real growth rates in parentheses. Errors and omissions account for the difference in the total for 1990-91 in this table and Table 1.2. Sources: Cenltal Statistical Organization, National Accounts Statistics. 1993; and Quick Estimates for 1992-93. 1.17 International Expenences. Declining investment and growth has been a frequent response to stabilization and reform elsewhere in the developing world, particularly in the 1980s. At that time, the debt crisis and global shocks in most developing countries brought about a protracted period of macroeconomic instability and lack of external financing which led to the adoption of stabilization programs accompanied by drastic policy reforms. Common features of these economic programs have been fiscal contraction, liberalization of external trade, and liberalization of domestic financial markets. A common objective has been to increase the role of the private sector in the economy. 1.18 In most cases, however, particularly in Latin America, there has been a drastic decline in capital formation, as a result of a decline in both public and private investment. Private investment fell in the initial phase of adjustment, and its response has been weak and slow to appear even in countries that made substantial progress in correcting macroeconomic imbalances, reforming the policy framework, and improving firms' profitability through drastic real wage cuts. Three factors help explain the slow recovery of private investment. * first, the adjustment to the interest shock of the 1980s required a large external transfer which under conditions of limited access to external financing led to contraction of aggregate demand. Output being determined in the short run by the demand for it, this contraction led to a decline in output growth and dius in private investment. One of the most robust results of empirical studies of investment behavior is that, because of their strong effect on expected returns, changes in output are one of the most important determinants of private investment.  - 10- * Second, in most countries, the implementation of stabilization and reform programs has not been straightforward. Delays and reversals have been frequent. These eroded the credibility of government policies and increased the uncertainty of returns on private investment. particular, empirical studies of private investment in Latin America, East Asia, ano so African countries indicate that while the real exchange rate level has an ambiguous and statistically insignificant impact on private investment, real exchange rate variability (which is an indicator of macroeconomic instability) has a strong and unambiguous negative effect on private investment. O Third, in most cases, fiscal contraction has been Table 1.8: The Rehltive Size of India's Transfer Problem, 1985488 carried out largely by (Percent of GDP) reducing public capital penduing. pubic capital aIndicators of the Size Indicators of the spending. This has had a of the Transfer ($; of Capaicity to Effect short-term direct negative GDP) the Transfer effect on aggregate demand Interest Total Debt as Debt and thus private Payment Exter3al % o' Service investment, and also an Debt Expotts as % of indirect long-term effect Exports because of the Highly debted complementarity between Argentina 4.2 48 517 63 compleentarity btween Brazil 3.6 37 314 44 public and private Chile 9.7 88 231 38 investment. In the 1980s Mexico 6.1 60 308 49 in Latin America, public Moderately hdebted investment accounted for India (1994) 1.4 36 233636 27 about half of total India (1985-90) 1.1 28 315 28 investment in Argentina Indonesia 3.7 64 240 36 Korea 3.2 21 50 25 and Chile, and more than Malaysia 5.5 57 76 25 one-third in Brazil. Thaland 3.1 36 100 26 Empirical evidence for a No:e: Interest payments and debt service are avetage for the period; debt is as of end group of Latin American of period. countries (Argentina, Brazil, Chile, Colombia, x Mexico and Venezuela) during 1970-85 suggests that a one percentage point decline in the share of public investment in GDP reduces the share of private investmnent in GDP by more than half a percentage point. 1.19 In sharp contrast with Latin America's experiences, East Asian countries such as Korea, Malaysia and Thailand have been able to adjust and reform their economies while maintaining growth rates well in excess of 6-7 percent. Three factors have accounted for this performance. First, stabilization and reforms have taken place without sUppages or reversals. In particular, the real exchange rate has remained competitive and stable throughout the adjustment period. Second, exports accounted for a much larger share of (3DP than in Latin America. The maintenance of a competitive real exchange rate made it possible to switch aggregate demand  - II - from domestic to external sources and thus contract domestic aggregate demand while expanding total aggregate demand. Third, public finances were stronger, allowing fiscal adjustment to take place without drastic cuts in public capital spenlding. Public capital spending as a share of GDP in Korea, Thailand and Malaysia only started to decline in the latter part of the 1980s when private investment was rising rapidly. 1.20 he Response of Prvate Investment in India. Compared to other developing countries, India's transfer problem has been much less severe than in Latin America, and even East Asia (Table 1.8). Its reform process has proceeded without reversals. The appreciation of the real exchange rate since March 1993 (para. 1.38) notwithstanding, the real exchange rate has not displayed the volatility whicl has been a problem in Latin America. However, while India has made remarkably rapid progress in liberalizing its investment regime, the legacy of India's past development policies could delay the response of private investment. 1.21 Because it was discouraged or prohibited in other sectors, Table 1.9: Trends in Capacity Utiliation- Use-based Classllcation private investment in India has 1970-1990 historically been concentrated in housing, agriculture, and _970-80 1980-90 1970-90 manufacturing. Investment in BaicGoods 57.8(4.5) 69.2 (3.1) 63.2 (1.5) housing is ulikely to lad a Intermdiates 941(40.4) 87.1 (0.1) 90.7 (40.6) housing is unlikely to lead a Capil Goods 65.2 (-1.9) 66.9(1.9) 66.o(0-3) recovery because of the absence of Consumer Goods 74.3 (4.0) 76.1 (0.6) 75.1 (4.3) housing finance and the obstacles Durables 84.- (.2.3) 78.9 (3.1) 81.9 (-1.1) created by the Land Ceiling A^t of Non-Durables 76.8 (-5.9) 75.6 (1.2) 76.2 (40.6) 1976, which makes any sale of Note: Dcade average. Figures in parentheses indicate the logarithmuc urban land subject to state trend in growth of capacity during the period. government approval. In Source: RBI. agriculture, private investment has been declining since the early 1980s as a result of (i) a policy framework which fragments India's domestic agricultural markets, and restricts private investment in wholesale trade, storage and agro-processing; (ii) declines in public investment in agriculture, which has a proven strong inducive effect on private investment in this sector (Box 1.1); and (iii) implicit taxation of agriculture through a number of crude policy instruments such as external trade restrictions and domestic price interventions. Large implicit and explicit subsidies for fertilizer, power consumed by farmers, and irrigation have partially offset the effect of this taxation at an extremely high fiscal cost exceeding several percentage points of GDP. As indicated in the 1993-94 Economic Survey, this has crowded out, however, more productive forms of public spending on agriculture. Unless steps are taken to improve the policy framework and increase profitability, private investment in agriculture is unlikely to recover. Regarding manufacturing, India's past industrial policies have left a legacy of a capital stock which is underutilized, and which should enable significant increases in production without addition to capacity. Past industrial policies have led to the proliferation of plants with less than economic scales of production (because the authorities have attempted to avoid market concentration which could result from industrial licensing); chronic idle capacity  - 12 - (because idle capacity was a key reason for denying licenses, established firms had a built-in incentive to maintain idle capacity to keep out potential entrants), and lack of specialization (most Indian firms produce an unusually wide range of products because it was easier to obtain a license for new products than for expansion within the same product line). These industrial policies have resulted in fragmentation of production, low capacity utilization (Table 1.9) and slow growdh of total factor productivity. In addition, high effective protection for capital intensive manufacturing sectors increased the capital intensity of manufacturing gradually but persistendy (Graph 1). GRAPH I TOTAL FACTOR PRODUCTIVITY. LABOR PRODUCTIVrTY CAPITAL PRODUCTIVITY AND CAPITAL INTENSITY IN MANUFACTURING 440 X~ 420 t 380 4/ 360 / 3404 / 300/ 280 - 2804 2404 apo 2201 200 20- / / : ,6' *40 , / I 60- / \ 120 - -t Facto, Proaq 80. 6c - 40 - cap- P-ocj'.!cle* 20 20 i980 8965 '970 ,g'5 98e -98s5 R Source: I.J. Ahluwalia. 1991, Productivity and Growth in Manufacturing, Oxford University Press, Oxford.  - 13 - Box 1. I Constraints to PiMvate Inveshnent in Agnculfure Growth of private investment in agriculture has been declining from 2.8 percent per year in the 1970s, to 1.9 percent per year in the 1980s. Four factors seem to account for thts decline. }i, declines in publc investment in agricuiture reduces its profitabiity and thus private investments in this sector. Research conducted on the basis of data over the 1960s and 1970s, sLuggests that public investment in rural physical infrastructure (roads, electrification, canal irrigation, telecommunications); rural services (markets, agricultural research and extension); and human resource development have a strong inducive effect on private investment in agriculture and financial intetmediation in rural areas, and thus on total capital accumulation in the sector. The effect of public investment on output is large. Public investmtents in agriculture explain about 90 percent of the observed short-term ag, regate output growth during the 1970s, through both direct effects and induced effects on investments and input use by the private sector. However, after increasing by 7.9 percent per year during the 1970s, public investment in agriculture has declined by 3.8 percent per year during the 1980s. * Second, nmplicit taxation of agriculture (para. 1.21) lowers its profitability and thus private investmnents in the sector. The research mentioned above also suggests that price effects on private investments and aggregate output growth in the sector are relatively small in the short run, but large in the longer run. * Thind, the current policy regime discourages domestic agricultural trade, and thus pnivate investment. Most restrictions derive from the 1955 Essential Commodities Act created to ptevent anti-competitive practices when India was vulnerable to food shortages. While the Act has been successful at preventing anti-competitive practices, it has also provided the central and state govemnments with sweeping powers to issue notifications or Orders, to control and regulate the production, supply, distribution and prices of essential commodides. Virtually all agricultural cornmodities, either in raw or processed form, fall under its purview; foodstuffs including edible oilseeds and oils, cotton, jute, and cattle fodder including oilcakes and other concentrates. In addition to the ECA, there are a number of otler Acts and Orders such as the Maharashtra Raw Cotton Act, the Coffee. Tea, Rubber and Tobacco Acts, the Forward Contracts Act, the Agricultural Produce Markets Act, that regulate the production, distribution, storage and marketig of agricultural commodities. This legislation provides the cental and state govemtients with the discretionaty power at any time or location to regulate the quantity as well as the time for which essential commodities can be stored; direct any producer or dealer to sell stocks to government; and set the rate that can be charged for cold storage. In particular, this legislation imposes: * universal licensing requirements for wholesale trade, storage and processing of virtually all agricultural commodities; * movement restrictions whereby, for example, official pennits are required to move paddy out of Tamil Nadu and Andhma Pradesh, edible oil out of Gujarat and cottoo out of Maharashtra; * storage restrictions whereby wholesale dealers have to obtain storage licenses that specify the maximum quantity, and sometimes the period, for which particular commodities can be stored. Most states have licesitg and storage limits for rice (e.g., 20 tons in Maharmshtra, 25 tons in Punjab and And1mra Pradesh, 50 tons in Madhya Pradesh etc.), wheat (e.g., 40 tons in West Bengal, 75 tons in Madhya Pradesh). sugar (e.g., 2.5 tons in Kerala), pulses and edible oil. In some instances. as in Uttar Pradesh and Tamil Nadu, storage lirits apply to all food commodities; * cold storage restrictions that prevent the development of cold storage capacity in major fruits and vegetables producing states such as Uttar Pradesh and West Bengal; * general ban on futures and forward trading of agricultural commodities. * public orcurement through levies of rice and sugar whereby rice and sugar mils have to sell to the govenmnent a fixed proportion (40 percent in the case of sugar, and an average for different states of about 50 percent for rice) of their producdon at a price generally at least 20 percent below the domestic market price. In addidon, the tax system through multi-point and multi-agency taxation (e.g., octroi, centmal and state level sales taxes, excise tax, regulated markets "fees', toll duties) does not favor inter-regional trade, inhibiting regional specialization according to comparative advantage; through high taxation of packaging inputs, it also discriminates against the development of the agro-processing industry and the concomitant diversification of agriculture. There has been some progress in freeing-up internal trade in agriculturalcommodities. Zonal movementt restrictions fot wheat in the northem states were lifted in 1993; however, the transport of wheat by rail ino the southem states was prohibited. In the same year, the monopoly paddy procutement scheme in the hasnjavur district of Tamil Nadu was also suspended. Price and distribution controls on sugar molasses were abolished by the Center in June 1993. but the two largest producing states (Utnr Pradesh and Maharashtra) have subsequently reversed these changes. * Fourth private investment in agro-processing coninues to depend on govenmnent liens; and small scale reservation policies restrict the setting of large plats for rice and pulse milling, processing of wheat products (bread, biscit, pastry). confectionery, ice cream. pickles, poultry .red, and some oilseeds.  - 14 - 1.22 The reforms introduced since Jun= 1991 should lead manufacturing firms to adjust to the new economic environment by focusing production on fewer products, and merging and acquiring existing plants to exploit economies of scale. Thus, while available data do not allow definitive conclusions on the magnitude of this process, firms' mergers, acquisitions and spin- offs seem to have increased significantly over the last two years. In the medium-term, greater specialization and better exploitation of economies of scale will increase firms' productivity, but in the short run, they do not require significant investment. In addition, trade liberalization has reduced protection to capital intensive activities and improved incentives for export-oriented, labor intensive firms. Since by definition labor intensive firms require less investment to expand capacity per unit of output than capital intensive ones, the reorientation in the structure of production resulting from the new policies should lead to lower capital intensity in the manufacturing sector. This should increase growth in the long run, but the immediate effect will be reduced growth in private investment demand. 1.23 Opening new sectors of the economy has not yet led to a surge of private investment. In cases such as mining, the opening is too recent (February 1994). In the case of telecommunications, the May 13, 1994 National Telecom Policy is a radical change in that it aims at ending the monopoly of the Department of Telecommunications (DOT) in the provision of basic services. But again in this case, the change is too recent and it will take some time before the change in policy is implementei and translated into a regulatory framework conducive to private investment in this sector. 1.24 Regarding hydrocarbons, the development of India's oil and gas resources would greatly benefit from a closer association with financially strong and experienced international oil companies, which could help mobilize considerable resources for investment in India--thus helping the country reduce its dependency on oil imports which now account for about one- fourth of merchandise imports. Foreign investment plays a large role in the hydrocarbon sector of other countries. The international oil industry has a very active participation in offshore exploration and production in the largest Southeast Asian nations, including China, Indonesia, Malaysia, Thailand, Philippines and Vietnam. The major international oil companies have a substantial role in refinery and distribution in Thailand, Malaysia and the Philippines. 1.25 While there has been growing awareness of the need for greater reliance on international oil companies in the areas of exploration, development, and downstream activities, the government and the management of public enterprises have remained cautious. India is not a highly promising country for hydrocarbon resources, and it needs to provide favorable terms to compete with countries such as the Former Soviet Republics, China, and many others. PT us far, in spite of several rounds of offerings since June 1991 of offshore and onshore areas for exploration, few contracts have been signed because the terms offered were not internationally competitive. The 1993-94 Economic Survey indicates that "The Oil and Natural Gas Commission has now been converted into Oil and Natural Gas Corporation Limited and has commenced its operations under the new form of a public limited company. The disinvestment of 20 percent of its equity will be completed during 1994. Half of the disinvestment will be in European capital markets and the other half will be sold domestically". While this is a welcome  - 15 - step, it needs to be accompanied by a framework conducive to a larger private participation in the sector. 1.26 In power, Table 1.10: Financial Performance of the State Electricity Boards, 1991-95 India now allows full (Rs billion) ownership of power 1991-92 }992-93 1993-94 1994-95 Ceni p a n i c s b v Gross Subsidy on Sates 74 92 107 126 donestic and foreign to agriculture 59 74 83 96 private investors; an to domestic consumers 13 12 21 27 extended period of inter-stame 2 2 2 3 license of 30 years Subventions received from w i t h 2 0 - ye a r state governments 20 19 21 21 Surplus generated by renewals; and a 16 sales to other sectors 22 26 37 44 percent rate of return Uncovered subsidies 32 47 49 61 on assets guaranteed by the state Memo Item govenments. This Gross subsidy on sales (% of GDP) 1.2 1.3 ..3 1.4 new policy has Note: Subsidies are defined as the diffetence between tariffs tat would enable the SEEs generated close to 75 to cover their variable costs and tariffs actually charged. It thus does not include proposals amounting capital subsidies. Values for 1994-95 are projected. to Rs 20 billion for Source: Ministy of Finance, Economic Survey, 1993-94. over 32,000 MW of generation capacity, half of India's existing installed capacity and slightly more than the total increase in installed capacity scheduled to be achieved under the Eighth Plan. Memoranda of Understanding have already been signed between private investors and State Electricity Boards (SEBs). Some projects are at an advanced stage of negotiation, with power purchase agreements signed and counter-guarantees establishing the responsibilities of the SEBs and concerned states already approved by the centzal govermnent. However, further progress has been constrained by the poor financial position of most of the SEBs (see Table 1. 10 and Box 1.2), which limits their ability to pay for private power. In the absence of financially viable clients, developers are looking for central government counter- guarantees, which the latter has justifiably been unwilling to provide in the absence of clear evidence that the state governments are prepared to take the difficult political decisions required to make power generation and distribution financially viable. In the absence of such evidence, the fiscal consequences of providing guarantees are unpredictable and have potentially large destabilizing effects. As a result, however, it is expected that only 1-2 of the more advanced proposals will reach the implementation stage during 1994-95, and only a few more are likely to follow in 1995-96. Several states have shown concrete signs that they are determined to reform the power sector and one bold program has already started in Orissa (Box 1.2). However, until this process gathers momentum, private investment in the power sector is unlikely to reach economically meaningful volumes. A similar situation prevails in the case of roads, where the urgent need to increase investment has led the government to open corstruction  - 16 - and operation of toll bridges and roads to private investment. The response has thus far been limited, however, because the existing legal and institutional framework makes it difficult to acquire land and charge tolls (Box 1.3). Finally, while its significance is difficult to assess, the states' attitude towards private investment has probably acted as a deterrent which has had an impact across sectors (Box 1.3). BOX 12: Stale Power Sector Restructnrg Rkerowird. lThe states own b1e SEBs and other power gneraig conpanics, which together generate 75 percent of India's el;eccity supply and provide most of the e.stribution to final consumers. The lack of autonomy and politcally inspired tariffs have weakened most SEBs to the pomt of operticoal and financial crsis. Commercial losses of the SEBs are rising and already exceed US$1 billion per anum; as a result the SEBs have been accumulating arrears to their suppliers, including central govemment utiities, The cost of subsidies to consumers, when defined conservatively as the difference between tariffs that would enable the power sector to recover its variable costs and actual tariffs, accounted for about 1.3 percent of Lndia's GDP in recent years (about 1.1 percent was tor agriculture and the balmce for residential consumers). The cost of subsidies would approach 2 percent of GDP, if esdtmated as the difference between revemne from tariffs set to enable the sector to operate commercially (i.e earning returns to sezvice debt and equity raised from capital markets) and the actual taiffs. The dismna perfornance of the SEBs is the result of political interference by the state governmcnts. Although the Indian Electricity Act grats the state utilities considerable autonomy, in practice they must obtain state govemmentapproval often at the highest political level for most major decisions on investrents, tariffs, borrowing, salary and personnet policies. Most state governments prefer thir SEBs to maintain tariffi well below the cost of supply. Under the Electricity Act the reonsibility for power is shared by the central governmentand the states and theref e the central gove:nment's ability to influence state power sector policies, including their retail tariffst, is limited. Since 1991 the central govemment has attempted to promote reforms in the state power sector by: (a) limiting discretionary financing such as external fwndig and rsources from the Power Finance Corporation to SEBs meeting muum performance standards; and (b) allowing the central utilities to operate on an increasingly commercial basis (for example, cuttng power supply to states for which arrears had exceeded a certain level). The central government now intends to use its guarantee powers for private power developmen in the same manner. However, with few exceptions, progress at the st level has so far been limited and inffdiint t reverse the trend of poor operational and financial performance. Ja! ar Co7nference. -he cental government convened in OctDber 1993, a high level conference in Jaipur to discuss power stor reforms. The conference was attended by senior central government officials and representatives front vitually all stares and SEBs. A broad consenu was reached th restructuring the state power sector was Tirgently needed to improve operational efriciency and resource mobiization in the power sector and to create an enabling environment for private partcipatio The central goverment offered to assist stes willing to: (a) establish commercial, corporate type managementof generation, transmission and distribuion; (b) restrucure the finances of the SEBs including workouts of payables and receivables; (c) establish a policy framework providing for rtuctin and introduction of conpetition and transparent regulation; and (d) implement tariff adjustments allowing stare utilities to chage comnmfcial raes. Staus of Reform Prcess. Comprehensive restructuring stdies are being fonnulated with external assisance for Hatyana, Rajasthan and Uttar Predesh and, in the near future, possibly Bihar. These studies cover items (a)-(d) listed above as well as the pteparadon of detaied impnntaton plans for the recommended reforms and related high priority investments. States with the weakest SEBs have shown wiAlingness to examine radical optons for their power sectors. This situtation reflects not only their ralizadon of the eremely difficllt siuation of their SEBs, but also their understanding that "improving' the SEB at dLe margin is unlikely to bring about a sutinable impsvenenm Most saes, however, are sull moving slowly, including the ones with the generally better perfonning SEEs such as Maharahtra and Andhra Pradesh, as they do not perceive the need for reforn as acutely, or are unable to take acton ().awa). O,_s_a. The Govemment of Orissa has taken a step beyond restaicturing studies and has sought the cntr government and intional development banks' support to help implement a bold pTogram of reforms involving: (a) the creation of commercially- oriented geation, transmission and distibution compaie to replace the Oissa State Electricity Board (OSEB); (b) prvatization of some of them. (thermal generation and disibution) and pnvate sector parcicipation in the others (hydro generation and anmission); (e) conversion of OSEM into a reuatory agency, and (d) eletricity tariff adjustments. 1.27 Swiwiwy. Strong and sustained private investment growth is critical to the success of the reform program. Since July 1991, a number of radical steps have been taken to liberalize  - 17 - private investment (paras. 2.5-2.7' and few formal impediments remain. However, in many important areas of the econom-, the combination of sector-level institutional and policy frameworks not sufficiently supportive of private investment, resistance of public enterprises to private sector entry, or insufficimnt complementary public investment may delay the response of private investment to the liberalv7ation of the economy. Addressing this problem would require extending the reform process to sectoral ministries, the states, and public enterprises. It would also need to include further measures to deregulate factor markets, in particular urban land markets. Box 1.3: Insttutioal Constraints on Prate Investment Private Invesment in Roads Frrm dIe 1993-94 Economic Survey. "Roads have always been financed from budgetary sources and constructed by Pubtic Works Department. The budgetary allocationfor the Nationalf Highways in 1993-94 is Rs 5597 7crore, marking an increase of 16.5 percent over 1992-93. These outlays are not adequate to meer the challenge as stated above. The National Highways Act has been amended in order to enable levy of a fee on selected sections of National Highways. This will permit the private sector to particpate in construction, maintenance and operation of roads on Build, Operate and Transfer (BO) basis. However, a lack of legalframework governting such schemes has sofaur delayed its progress. f Th Rote of the States in Stimiating Private Investmen FromtheJuze.1993DiscussIonPaper 'Severalgovernmtentpolicypapershavehlghlightedthatforeignanddomesticprivateinvestment was affected by deficiencies in the provision ofpublic services and infrastructure, mostly the responsibily ofthe staes: 'the process of deregulation and debureaucratizaton of the industrial licensing system has evoked a strong positie responsefrom both producers and consumers. However, whilfetters on industrial investment andproducdon have been sha ply reduced at the Central Government level, it is important to recognie that they are still pervasive in many States. The requarementfor a'censes, permits and inspections at the State and local levels continue to be onerous and extract a heavy toall in terms of efforts and resources from industriW wnits. Enterprises contnue to face dffiulties in procuring land, water, and efectricity connections. Ultimately, it is the responsibility of individual states to improve the climate for industry." Inflaion 1.28 After declining to around 7 percent in mid-1993, inflation has been drifting upwards in the second half of 1993. It reached 9 percent in early 1994, and exceeded 10 percent in early April 1994. Cost and demand factors have played a role in this acceleration of inflation. Close to 40 percent of the 26.2 percent cumulative increase in the wholesale price between June 1991 and December 1993 (Table 1.11) is accounted for by increases in food prices (3.1 percent); the lifting of controls over previously controlled prices (1.2 percent for iron, steel and steel products in January 1992; phosphatic fertilizers in August 1992; lubricating oil in November 1993); and increases in still administered prices (5.4 percent for petroleum products, power tariffs, sugar, coal and urea). Increases in several administered prices in February 1994 (rice, wheat, petroleum products, para. 1.9) have added additional pressure. Procurement prices of food grains have increased as their international equivalents have risen both because of the devaluation and increases in the international prices of wheat and rice. While increases in administered prices strengthen the public sector financial position and reduce inflation in the medium-term, in the short-term their immediate effect is to accelerate inflation further.  - 18 - Table 1.11: Evolution of the Wholesale Prke Index, 1991-93 Weight June 91 June 92 Jr-ie 93 December 93 WPI 100.00 100(11.2) 113.0(13.0) 122.5 (8.5) 126.2 (8.2) 26.2 Primary Articles 32.30 100 (8.3) 112.6(12.6) 116.9 (3.9) 123.2 (8.5) 7.5 Food 17.39 100 (0.6) 119.4 (19.4) 121.6 (i.8) 1273 (6.2) 4.7 Food grains 7.92 100 (18.6) 126.9 (26.9) 124.9 (-1.6) 139.4 (12.6) 3.1 Non-Food 10.08 100 (10.1) 103.7 (3.7) I07.4 (3.6) 117.1 (11.9) 1.7 Mineals 4.83 100 (6.4) 103.6 (3.6) 122.5 (18.3) 122.5(17.2) 0.9 Fuel, Power, Lubricants 10.66 100 (9.2) 112.6(12.6) 133.2 (18,2) 140.0(13.2) 4.2 Manufactured products 57.04 100 (9.4) 113.3 (13.3) 121.0 (6.8) 125.6 (6.9) 14.5 Food products 10.14 100(12.0) 110.5 (10.5) 121.5 (9.9) 123.5 (9.8) 2.4 Textiles 11.55 100 (5.1) 109.4 (9.4) 116.7 (6.6) 122.8 (9.4) 2.6 Chemicals 7.36 100 (6.5) 115.8(15.8) 129.1 (11.5) 132.3 (5.0) 2.4 Metal and Metal Products 7.63 100 (8.7) 110.9(10.9) 116.2 (4.7) 122.3 (8.1) 1.7 Machitny 6.27 100 (9.5) 114.7 (14.7) 119.3 (4.0) 119.8 (0.4) 1.2 Memo-Items Administered Prices 15.93 100 110.6 130.2 134.0 5.4 Petroleum and gas 4.27 100 101.5 123.4 123.4 1.0 Petroleum products 6.67 100 109.3 129.9 129.9 2.0 Coal 1.26 100 127.4 146.9 150.2 0.6 Electricity 2.74 100 113.0 134.3 155.3 1.5 Urea 0.99 100 130.0 127.9 127.9 0.3 Decontro Prices 1.2 Iron and steel 2.44 100 113.7 117.0 123.7 0.6 Phosphatic fertiizers 0.18 100 130.0 307.7 306.6 0.4 Superphosphate 0.06 100 130.0 245.3 292.3 0.1 Ammonium phosphate 0.12 100 130.1 315.4 315.4 0.3 Lubricatig oil 0.45 100 118.5 160.3 160.3 0.3 Notes: Twelve months point-to-point increase in parentheses. The I st folumn indicates each item contribution to the WPI increase, that is the index item percentage change imes the weight of the item in the WPI. Source: Ministy of Finance, 1993-94 Economic Survey. 1.29 On the demand side, the monetization of capital inflows has led to a sharp increase in base money (25 percent, para. 1.6). This increase in liquidity was particularly rapid in the latter part of 1993 and the first few months of 1994. Together with the increase in administered prices of February 1994, it contributed to the acceleration of inflation in early-April 1994; it has also created the potential for a significant further acceleration of inflation in the next few months.  - 19 - Table 1.12: Domestie and Internationd Prices of Wheat and RIce, 1990-94 Procurment Prices International Prices Nominal Protection Coefficients (Rs/kg) (Rsfkg) Rice Wheat Rice Wheat Rice Wheat (Imp) -(Exp) (Imp) (Exp) 1990-91 3.2 (59) 2.3 (100) 5.4 2.3. 043 0.51 0.64 1.14 1991-92 3.6 (49) 2.5 (76) 7.4 3.3 0.43 0.50 0.69 1.35 1992-93 4.2 (52) 3.3 (80) 8.1 4.1 0.56 0.66 0.55 0.88 1993-94 5.0 (50) 3.5 (8t) 10.0 4.3 n.a. n.a. n.a. n.a. Note: Nominal protection coefficients refer to the ratio of domestic to international prices; the colunmn (exp) indicates that the international equivalent is calculated assuming the conmmodity is an exportable and (imp) that it is importable. Figures in parentheses indicate the ratio of domestic procurement prices to intenational ones. Procurement price for rice is for the fine variety. Soures: Ministry of Agricultue and Bank Staff estimates. Recent Developments in Money and Capital Mlarkets 1.30 Since July 1991, there have been several important developments in India's money and capital markets. 0 [irst, as a result of some decline in inflation and relatively rapid growth of money aggregates, nominal interest ates have been declining gradually but persistently since mid-1992-93 (Table 1.13). For ex. iple, the upper range of (unregulated) interest rates on certificates of deposits has declined from over 20 percent to around 16-17 percent during the last quarter of 1992-93 and 1993-94. Call money rates declined from 11-13 percent to around 5 percent. Maximum (regulated) deposit rates declined from 13 percent to 10 percent, although in recent months actual rates have been about 2 percent below the ceiling. Measured by the difference between 364-day Treasury bills and WPI inflation, real interest rates have increased and then stabilized at around 4 percent. Relatively high liquidity in money markets and slow growth in credit to the commercial sector (Table 1.14) led the RBI to reduce minimum lending rates for working capital from 20 percent in the last quarter of 1991-92 to 15 percent in the second half of 1993- 94. * Second, these reductions notwithstanding, the real value of the minimum lending rate (MLR) has remained relatively high. The market perception is that, if the MLLR were removed in the current liquid conditions, lending rates would decline to around 12-13 percent--the rate paid by better finns on debentures and by government on 5-10 year maturities bonds--and thus that the yield curve is maintained artificially steep. There is also a perception that this artificially high MLR is the main reason for the stagnation of bank credit to the commercial sector and firms increased recourse to domestic and international market (see below). The RBI has maintained a relatively high MLR for two reasons. The first is to maintain a relatively high spread for  - 20 - Table 1 13: Key Interest Rates, 1990-941| Treasury Biles" Call Money 364-day 1824ay 91-day Minmum Maximmn` Certificates of Inflatone Rate Lending Rate Deposit Rate Deposit' (Bombay9' 3990-91 June 13.5 .. 10.0 4.6 16.0 10.0 10.0 - 16.3 9.7 September 15.2 .. 10.0 4.6 16.0 10.0 10.0- 14.0 7.9 Decenber 13.6 .. 10.0 4.6 16.0 11.0 10.0- 13.1 12.6 March 18.5 .. 10.1 4.6 16.0 11.0 10.0- 14.9 12.1 1991-92 June 24.8 .. 10.0 4.6 17.0 12.0 12.0- 16.8 12.2 September 12.8 .. 10.0 4.6 18.5 13.0 11.5 - 16.0 l5.9 December 12.7 .. 10.0 4.6 20.0 13.0 12.5 - 17.6 14.3 March 14.3 .. 9.3 4.6 19.0 13.0 12.0- 17.0 13.6 1992-93 Jtum 15.8 11.4 .. 4.6 19.0 13.0 12.3 - 25.0 12.3 Sepem r 11.4 11.3 .. 4.6 19.0 13.0 13.0 - 20.0 10.2 December 11.2 11.2 .. 4.6 18.0 12.0 12.3- 17.5 8.4 Match 13.9 11.1 .. 11.0 17.0 11.0 12.5- 16.5 7.0 1993-94 June 8.0 11.4 .. 10.1 16.0 11.0 12.0- 16.5 7.1 Septmber 5.0 11.3 .. 9.1 15.0 10.0 n.a. 7.3 December 5.3 11.2 .. 8.6 15.0 10.0 n.a. 7.3 N_ : it Unless otherwise specified, intrst razeyie are those prevaling at drc end of the month. Si Average for the month. V Implicit yield at cut-off price (for the Mgst auction in the month). 364day Trasuy Bills were introduced in April 1992, and ate sold dthough periodic auctions. No fresh 182-day Twasury Bills were issued afler April 16. 1992. Since January 1993, 91-day Treasury Bills are being perdally auctioned. Earler they were sold on tap at 4.6%. V Refts to rate on term deposit. Up to Apri 1992 ras were fixed for different marits. Sbice Apri 1992 only a maximun deposit rate is specfi. 6' Effecdve interest rate (range) of CDs of all mamrities, issued during the iast fonnight of the month. a& Wholesale price index, anlual increase. point-t-point banks, profits from which contribute to recapitalization. The second reason is that with the RBI committed to reduce the CRR and SLR, and in the absence of a well developed secondary market for government securities, the MLR becomes the RBI's principal monetary policy lever: by keeping the MLR high, the RBI limits credit expansion, and hence deposit creation. * Third, primary markets for govenument debt are developing rapidly; sxcondary markets more slowly. As a result, instruments of monetary control which had traditionally focused on the multiplier of base money are now gradually shifting to the control of the money base itself. Until July 1991, the main impediments to the development of a government securities market had been: (i) low yields on government obligations, which meant that the demand for such obligations came almost entrely from entities forced to hold them; (ii) auction procedures in  - 21 Ta1 14: Issues by Publi and Prlvkte COmpaIdes. 1989-9 (Rs billion) 1989-90 1990-91 1991-92 1992-93 Private 79 (940) 64 (1,074) 123 (1,243) 209 (1,328) Equity 20 (751) 29 (841) 43 (86) 102 (1.117) Debemures 59 (189) 36 (23}) 80 (375) 107 211) Government 42 (21) 62 (71) 71 (20) 4 (3) Equities 1 (5) 2 (14) 1 (3) 3 (2) Bonds 41 (6) 61 (17) 70 (17) 1 (I) Total 121(961) 26(1,105) 194 (1,263) 212 (1,331) Memo Item Total as % of GDP 2.7 2.4 3.2 3.0 Notes: Number of issues in parentheses. Source: RB!. primary markets that failed to reflect market conditions; (iii) a limited range of Treasury instruments, particularly short-term; (iv) lack of a dealer network; and (v) inadequate transactions and custodial systems. While further steps need to be taken to develop a dealer network and improve transactions and custodial systems, the measures taken over the last two years have enabled the RBI to increase gradually primary issues of both treasury bills and "dated" securities (bonds with maturities exceeding one year). In April 1992 the RBI introduced fortnightly auctions of 364-day T-bills, which have also been extended to 5 and 10 years dated securities. In January 1993, it began auctions of 91-day T-bills. Auctions have also been extended to 5 and 10 years dated securities. In January 1994, the government successfully auctioned Rs 30 billion in five-year zero-coupon bonds for the first time. FinaJly, in May 1994, the RBI announced its intention to establish a system of primary dealers. * Fourth, the role of capital markets has increased sharply. With the lifting of restrictions on firms' access to capital markets, private issues of equity and debentures in India's domestic capital markets rose to Rs 210 billion in 1992-93, i.e. more than tripled in relation to 1990-91 (Table 1.14). An additional Rs 75 billion was mobilized in international capital markets (Table 1.17). At the same time, however, reflecting a decline in their creditworthiness, resources mobilized by PEs fell from over 1 percent of GDP in 1990-91 and 1991-92 to a negligible amount in 1992-93.  - 22 - Table 1.15: Sdected Monetary Indicators, 1990-94 (Rupees billion) Stocks (End-March of each year) Money aggregates 1990-91 191-92 1"2.93 1"3-94 Sources of Resee Money 878 (100) 995 (100) 1,109 (100) 1.386 (100) Net RBI credit to Government 888 (149) 940 (44) 984 (39) 986 (0) Net foreign exchange assets (RBI) 80 (19) 188 (93) 26 (33) 514(104) Other assets (net) -91 (-68) -133 (-37) -101 (28) -114 (4) Sources of Broad Money 2,658 (100) 3,170(100) 3.668 (100) 4,320 (100) Net bank ceedit to Government 1,402 (66) 1,583 (35) 1,762 (36' 2,041 (43) Credit to co=mrcial sector 1,718 (58) 1.880 (32) 2,201 (65) 2.359(24) Netforeignexchangeassets 106 '11) 212 (21) 250 (8) 537(44) Other asses (net) -567 (-35) -505 (12) -548 (-8) -617 (-II) Memo Item.: M3/Bace Money 3.03 3.19 3.31 3.12 M3IGDP 0.50 0.51 0.52 0.54 Growth rates Reserve money 13.1 13.4 11.5 25.0 M3 15.1 19.3 15.7 17.8 Nominal GDP 17.8 16.0 14.6 13.0 Note: The flow as a percentage of the change in base money or the change in broad money stock is in parentheses. Increases in foreign assets following a devaluation are offset by decliaes in other assets. Source: RBI. Balance of Payments 1.31 The Ciurrent Account. The dramatic improvement in India's external accounts, both current and capital, is one of the most remarkable results of the stabilization and reform measures taken since July 1991. The current account deficit declined from US$10 billion in 1990-91 (3.5 percent of GDP, Table 1.16), to US$2.9 billion in 1991-92, US$5.3 billion in 1992-93, and US$0.8 billion in 1993-94 (0.3 percent of GDP). After two years of stagnation, partly the result of the collapse of exports to the Former Soviet Union, exports grew over 20 percentr in 1993-94. This growth is broadly based in terms of markets (exports to OPEC countries grew by 34 percent, to non-OPEC developing countries by 54 percent, and to East Asia by 61 percent) and commodities (agricultural products, ores and minerals, gems and jewelry, chemicals and garments). Several developments explain this export recovery. The depreciation of the real exchange rate has significantly increased exports' competitiveness (Table 1.19); the reduction of tariffs, together with the slowdown in domestic demand and the expectation of further tariff cuts have led firms to reorient production toward export markets; and improvements in the administration of export promotion schemes have provided exporters better access to intermediates and raw materials at international prices. On the other hand, non- oil imports have declined from US$22 billion in 1990-91, to US$15 billion in 1991-92, and US$17-18 billion in the subsequent two years. While the slow growth in manufacturing reduced  - 23 - TabLe 1.16: Balnce of Payments, 19097 (USS billion) Actuals Projected 90-91 91-92 92-93 93-94w 94-95 95-96 96-97 Exports, fob 18.5 18.2 18.8 22.6 25.9 29.6 33.8 Imports cif 27.9 20.3 22.9 24.4 28.2 32.2 36.5 olw Crude Oil & Petrotum o.0 5.4 6.1 5.7 7.0 7.8 8.7 olw Capital Goods Imports 5.8 4.2 4.5 n.a. n.a. n.a. n.a. Trade Barance -9.4 -2.1 -4.1 -1.8 -2.3 -2.6 -2.7 Nonfactor Services (net) 0.8 0.7 0.2 1.3 t.3 1.3 1.4 Net Facot Income -3.8 -4.1 -3.6 -3.7 -4.1 -4.1 -4.1 Private Transfers (net) 2.0 2.7 2.2 3.5 2.6 2.6 2.5 Curreat Account Balance -10.4 -2.9 -5.3 -0.8 -2.6 -2.7 -2.9 Capital Account 7.6 3.9 5.0 9.1 4.3 4.7 3.7 Foreig Investment bt 0.2 0.1 0.4 4.7 3.0 3.0 3.0 Official Assistan 2.z 3.4 2.1 2.6 2.1 1.8 2.0 Loans 2.4 3.0 1.7 2.1 1.7 1.4 1.6 Disbursemnts 3.6 4.4 3.4 4.0 3.8 3.8 4.1 Amortaion 1.2 1.4 1.7 1.9 2.1 2.3 2.5 Grants 0.5 0.4 0.4 0.5 0A 0.4 0.6 Commercial Borrowing (get) cl 4.1 2.0 1.5 2.5 40.1 0.5 -0.6 Nonresidt Deposits dl 1.5 -0.5 1.9 0 0 0 0 Bilaterat Arangemnts e -1.0 -1.2 -1.0 -0.7 -0.7 -0.7 -0.7 Net MFCredit 1.0 0.8 1.3 0.2 -1.1 -1.6 -0.9 Changp in Gross Reserves 1.8 -3.4 -1.0 -8.6 -0.7 -4.4 0 Memo Items: Current AccountlGDP (perit) -3.5 -1.2 -2.2 .0.3 -1.0 -1.0 -1.0 Gross Foreign Bxchange Reserves 2.3 5.7 6.7 15.3 16.0 16.4 16.4 in months of lmpom (goods) 1.0 3.4 3.5 7.8 7.0 6.3 5.5 Exterl Debt (Percmnt of GDP) 28.3 33.9 37.6 37.6 35.9 33.9 31.9 Debt Serice (Percen of jxports) 27.7 29.8 29.8 27.9 30A 29.1 29.8 a? Preliminary esitates. bi Includes drect and pottfolio investment. ci Inclhdes private non-g eand anhorttenr debt, and vation changes. dl Net flows in noesident ndiandepositschemes. excgthe wno-epatbNR(NR)D Scme (Box 1.9). el Servicing of the Russi debt. Soumes: Government of Idia, Reserve Bank of India, Miniy of Commce and Staff esoimates. demand for imported intermediate inputs, the 1993-94 Economic Survey of the Ministry of Finance suggests that this decline also results from a lower import intensity of production in response to the depreciation of the real exchange rate and the new economic policies. 1.32 Prospects for the Current Account. Provided the authorities are able to maintain the competitiveness of the real exchange rate, prospects for maintaining or even exceeding 1993-94  - 24 - export performance are favorable. The external environment is expected to Boy 1.4: Instruments Used by Foreign lfec and Poefolio improve compared to the 1980s. At 3.4 Investors percent for the remainder of the decade, G'loeal DQcas_goa Recetits (GDR) are egquit instruments created by the weighted GDP growtlh of India' s a so.called Overseas Depositary bank (ODB) authotized by the issuing company to itsue outside India GDRs to non-resident investors trading partners is slightly weaker than against the shates dettvered to a Domestic Custodian Bank who the 3.5 percent achieved during the instructs the ODD to issute GDRs against the shares it holds. A 980s. Howver, at round onetenth of company wilhng to ratse foreign fund through GDRs is required to 1980s. - However, at around one-tenth of obtain prior permission from the Department of EconomRic Affairs at one percent, India's import penetration the Ministry of Finance. The shares correspond to the GORs in a ratios in major industrial country markets fixed ratio (for example I GDR can represent S shares). The GPRs may be issued in a niegotiable form, anid are typically listed in a are extremely small. Even in the clothing maY biss does not tax capital gains and can be tmded on sector, India is not a major supplier; it international computerized networks. GDRs can be redeemed at the accounts for only 1 percent of price of the corresponding ordinary shares of the issuing company at the date of redemption. The Indian authorities treat GDRs as diect consumption in the European Community investment in the issuing company and are subject to the ceiling on and in North America, and for a foreign equity participation. considerably smaller share in Japan. Euro-Convertible Bonds (ECB) are bonds subscribed by a non-resident China, though a relatively newcomer as a in foreign currency and onverible into ordinary shars of the issuing major exorter, as notaby large shares company. The same authorization procedure that applies to GDRls major exporter, has notably larger shares holds for ECBs and are treated as direct investment in the issuing than India. The expansion of India's company. exports to industrialized countries will thus be driven mostly by India's domestic policies. The shift in composition of trade towards fast growing countries in East Asia should suipport an acceleration of exports--fast growing East Asian industrializing countriks now accounit for 12 percent of India's exports and Japan accounts for another 10 percent. In addition, the liberalization of textile trade under the Uruguay Round of negotiations concluded in Geneva in December 1993 should provide some further support to the growth of India's exports in the second half of the decade. Finally, the rescheduling of India's US$10 billion debt to Russia (repayable in rupees) has established a payments mechanism which should help restore exports to Russia. The future evolution of the current account is expected also to benefit from relatively low international real US$/LIBOR interest rates which, compared to the 1980s, the World Bank projects to be down by 300 basis points. As of March 1994, 45 percent of India's estimated US$93 billion external debt was at variable interest rates. 1.33 Based on these prospects, exports are projected to increase in real terms by around 11-12 percent in the next three years, less than the 17 percent real growth achieved in 1993-94 (Tab!e 1.16). Assuming a GDP growth rate of 4.5-5.5 percent in the next three years, import growth is expected to accelerate from about 6 percent in 1993-94 to around 12-13 percent, as a result of continued trade liberalization and reactivation of the economy, implying a relatively high non- oil import elasticity of around 2 for the next few years. Based on this, the trade deficit is expected to rise to US$2.3 billion in 1994-95, and remain at about this level in the following two years. As a result of these developments, India's current account deficit is expected to be around 1 percent of GDP in the next few years. The external debt to GDP ratio is projected to decline from 38 percent at present to 32 percent by 1996-97. Evidently, the dramatic changes  - 25 - introduced in India's policies render more than ordinarily uncertain any projection of the balance of payments made on the basis of historical parameters. Indicative of the difficulty of projecting the future in a rapidly changing environment, the strengthening of India's current and capital accounts in 1993-94 has been far stronger than had been anticipated a year ago. I Ta_ble 1.17: Foreign Direct and Portfolio InvestmentS- (US$ million) 90-91 91-92 92-93 93-94 Direct Invesunent Foreign Direct Investment I/ 165 148 344 600 Portfolio Investment Foreign Institutional Investment 0 0 1 1,600 Euro-Isses/GDR 0 0 241 1,510 Euro-Convextible Bonds 0 0 0 995 Total Portfolio Investment 0 0 242 4,115 Total Direct and Portfolio Investment 165 148 585 4,715 t/ Includes direct investment by foreign investors even if their share is less than 25 percent of the equity capital and non- resident Indian investments. These investments used to be classified under portfolio investment. Source: Ministry of Finance. 1.34 The Strengthening of the Capital Account. Foreign direct and portfolio investment increased from less than US$200 million in 1990-91 and 1991-92 to US$600 million in 1992-93, and US$4.7 billion in 1993-94, with a dramatic acceleration in the second half of 1993-94 (Table 1.17). These inflows are the result of the government's February 1992 Budget decision to allow private and public Indian firms in good financial standing to raise funds abroad through convertible diebentures and equity issues, and the govermnent's September 1992 decision to permit Foreign Institutional Investors (FIIs) to operate in India's capital markets. The total investmenit volume by FIls is not restricted. They are allowed to invest in all non-government securities traded in India's primary and secondary markets, including debentures and shares of private and public enterprises. No more than 24 percent of issued share capital in any one company may be held cumulatively by FIIs, and no more than 5 percent may be held by any single FII. No more than 30 percent of FIIs' portfolio can be held in debt instruments. The tax rate on dividend and interest income is 20 percent; the tax rate on capital gains is 30 percent on gains realized before one year, and 10 percent thereafter. 1.35 About US$0.6 billion of the US$4.7 billi.A of foreign investment in 1993-94 consists of direct investment. About US$1.6 billion consists of investment in equity shares exclusively by FPM. attracted to India by the prospects of dividends and capital appreciation; and about US$2.5 billicn consists of investments by foreign investors in equity shares (US$1.5 billion) and debentures (US$1 billion) issued by Indian firms interested in raising capital abroad at a lower  - 26 - cost than what is avai!able from domestic sources. The debentures are convertible, and carry interest rates of about 3-4 percent. 1.36 Such inflows could continue over the next two-to-three years. First, the pipeline of foreign direct investment continues to build up rapidly. Commnitments are at about US$2 billion a year (and rising); under stable macroeconomic conditions and no policy reversals, actual foreign direct investment should gradually increase towards that level. Second, India is at present under-represented in the portfolio of FlIs so that the growth of portfolio investment flows to India could exceed the growth of these portfolios for some years to come. With a market capitalization of US$87 billion, India's capital market is among the largest in the world. In theory, Flls could own up to 24 percent of this market. In addition, while thus far FIIs' investments have been exclusively on equity shares, the potential for investing in debt instruments is considerable. Third, to the extent domestic rates remain above international ones, Indian firms will continue to have incentives to mobilize resources abroad. Table 1. 18: Portfolio Investment in Selected Countries (US$ bolion) Market Capitalization Average Portfolio Average Portfolio US$tb Inflow as on December 1992 Investment During the investment as Percentage of Period 1989-92 Percentage of Merchandise Exports CapitalizatioD in 1992 India (Bombay) 65 0.4 0.6 53 Mexico 139 5.9 4.2 3.6 Korea 107 2.3 2.2 1.3 Taiwan 101 n.a. n.a. n.a. Malaysia 94 0.3 0.3 2.5 Thailand 58 0.7 1.1 3.1 BRazi (SAO Paulo) 45 2.2 4.9 2.8 China 18 0.8 4.3 1.4 So Portfolio ln"e'tmnt in Developing Counties - World Bank Discussion Papers, Deceber 1993, IFS. 1.37 Compared to Latin American and East Asian countries, the inflows in India have three distinctive features. First, contrary to its East Asian neighbors, where a large share of the inflows consisted of foreign direct investment, inflows in India are mostly portfolio investment. Second, unlike Latin American countries where short-term capital and bank deposits were predominant, India's consist of investment in equity and debentures which are costlier to reverse- -both because of the differential taxation on short and long term capital gains (para. 1.34) and because significant sudden market reversals could imply capital losses. Third, because of its portfolio nature, the capital inflows in India have no direct effect on the banks' deposit base. Monetary effects take place through increases in base money resulting from the RBI monetization of the inflows. 1.38 However, capital inflows have surged at a time when the current account deficit is low and are putting downward pressure on the exchange rate. The RBI has thus far maintained the  - 27 - Tablc 1.19: Real Exchange Rate of India's Main Trading Partners and Competitors 1981-1993 (End of Period) 1993 Export 1981 19SQ 1990 1991. 1992 1 111 IV Sbare India 0.93 1.06 1.00 1126 1.30 1.39 1.30 1.31 India's Main Market USA 20.0 1.20 1.05 1.00 1.02 1.01 0.99 1.00 1.00 Japan 12.2 1.46 1.09 1.00 0.95 0.97 0.91 0.84 0.90 Gennany 8.0 1.69 1.15 1.00 0.99 1.05 1.05 1.05 n.a. UK 7.2 1.56 1.28 1.00 0.99 1.19 1.17 1.15 n.a. Belgium 5.4 1.76 1.19 1.00 0.98 1.02 1.01 1.05 1.08 France 2.8 1.74 1.16 1.00 0.98 1.02 1.00 1.03 1.07 Neherlands 2.4 1.63 1.14 1.00 0.98 1.02 1.01 1.02 n.a. India's Main Conmetitors Indonesia 0.81 1.10 1.00 1.05 1.06 1.04 1.04 n.a. Malaysia 1.03 1.03 1.00 0.97 0.88 0.87 0.85 n.a. Philippines 1.17 0.93 1.00 0.88 0.84 0.87 1.01 n.a. * Tailand 1.15 1.10 1.00 0.98 1.00 0.99 0.97 n.a. Korea 1.13 1.02 1.00 1.04 1.06 1.06 1.07 1.07 Singapore 1.04 1.13 1.00 1.06 1.09 1.08 1.06 n.a. Hong Kong 1.40 1.11 1.00 0.91 0.82 0.82 0.77 n.a. n.a. not available. Note: Index of a country's nominal exchange rate vis-a-vis the US$ divided by this country's wholesale price index or, ff not availble dthe consumerprice index. Sow'rce: IMF an Bank Staff estimates. exchange rate constant in nominal terms by purchasing all the excess supply of foreign exchange at that rate. With inflation at 8-9 percent during 1993-94 and over 10 percent since April 1994, this has produced a real appreciation of the rupee which may undermine continued strong export performance (Table 1.19). D. The 1994-95 Budget Highlights 1.39 The 1994-95 Budget presented to Parliament on February 28, 1994 is this government's fourth. While continuing the process of structural reforms in several key areas, in particular taxation (para. 2.17 and Box 1.6), its major objective is to reactivate investment. * First, the investment climate has been improved by the decision to establish near full current account convertibility and reduce tariffs, thus signalling the governent's commitnent to  - 28 - continue liberalizing the trade regime and Box 1.5: From the 199495BRdget Speech integrating India into the world economy--a Opening New Sectors to Private Investment ... In my Budget signal of considerable importance to foreign speech last year, I had announced the establishment of a High- investors. Powvered Committee to study the insurance industry and make recommendationw on directions for its development in fiur.e. The Commttee on R<efrms in the Insurance Sector was a Second. a series of measures were intended appobied under the Chairmanship of Shri R.N. Aathotra, to reduce the user cost of capital. In foamr ove'.or of the ReserveRankof na TheCommiee tariff reductions were has recewty submitted its report, which underscores the needfor particular: (i) progres3tvederegulation of the insurance sector to create a more particularly pronounc-ed for capital goods; (ii) comeeMtitve and financialy strong insurance industry, banks' minimum lending rate for investment jwndioning under an independent regulatory authority. De repon is now under active consideration of the Govermment. It purposes was reduced by one percentage is my intention to evolve a brad national consensus about the point to 14 percent; (iii) as part of a major future diretion and content of reform in this important sector.. tax reform (Box 1.6), particularly of excises, ... Sigtnflcnt steps have been taken in the oil and the cost of capital was reduced by allowing gas seaor to promote vestment includingprivate investment in firms to credit excises paid on purchases of exploration developmnmt, reffning and mareting. We propose to deepen and intensify these initiatives. To promote equipment against tax liabilities; and (iv) the moderisatn and investment in the coal industy, Govermnent tax on corporate income has been unified and is reewing the policy frwaewrk for nvestment, picing and reduced to 46 percent, from 52 percent for disributon. New iniiaives are under consideration in the rdecomwicaio n s ectors.., widely held companies and 58 percent for Improving the Funewoning of Captl Markets ... The other companies. Govenmuent artacha high priority to reforms of the capital markets amed at creaing an efficient and competitive capual 0 Third, the government announced it would mare subject to effectve regulation by the Secuities andan xcange Board of india (SER) vwhich will esare adequate consider e recommendations of an expert invessorprtoecdon. After a tepoary setbackin 1992following committee to reform the insurance industry, thesecres scam thecapitalmarketrecoveredground qzucy. currently a public sector monopoly, and ...he Government is committed to a thorough modenisatdon ofhe cap ioamarwaedropidi rovementoftradngpractes indicated that barriers to private sector entry wh a view to ensurng transparecy and speed of settlements. in this and other areas thus far reserved for The mode National Stock Exchange wih screen-based trading it exeted t begin operation by the middle of this year. Te public sector nvestment would be reduced as establishment of a Depository System of scripless trading is well (Box 1.5). anotheriqportantobjective. Governmentnedsto bring before Parlint separate legislation for the establirbment of Deposiries. The Governmnet also proposes to m*ake frther 0 Fourth, the government indicated that amendmnts to the SEW Act and the Securities Contracts measures would be taken to improve India's MeRgulation) Act in order to give additional powers to SEEI.. stock markets' tradig and settlement Budgetfor 1994-95, Minister of Fiance's Speech. practices--whose weaknesses had constrained the development of the country's dynamic stock markets (Box 1.5). * Fifth, the government announced its intention to begin reforming the rural financial system. Although small in relation to India's overall financial system, the rural fmancial system has been decapitalized over the 1980s, and its ability to lend to agriculture seriously eroded. * Sixth, the government has taken further steps to redirect expenditure towards social sectors. Cuts made in budgetary funding for important social programs in 1991 were restored in 1992-93, and the 1993-94 budget included substantial increases in funding for primary education, endemic  29 - Box 1.6: Main Tax Reforms Intduced in the 1994-95 Budget Customs Ine budget has continued the process of tax reform started in July 1991 by {i} reducing the maximum rate from 85 percent to 65 percent; (ii) rationalhzing (by bringing tatiff rates on outputs below those on inputs) the tariff structure for major groups of goods (in particular capital goods, metals and mietal products, and petrochemicals); and (iii) eliminating about 350 of the existing 500 exemptions. Excises The budget has taken a numberof measures to implement the ruommendationsof the Tax Comnumtee and to bring the excise system closer to a value-added tax. * First, it has expanded the coverage of the MOUVAT to include petroleum products, textiles. and capital goods. The taxation of petroleum products will be sinplified by replacing specific rates with a uniform 10 percent ad valorem rate. The taxation of textile goods and inputs will be simplified by adopted a compressed ad valorem rate structure of 5 percnt, 10 peret, and 20 percent. The Budget reduces the total number of ad valorem MODVAT rtes by half. It reduces the number of special notification exemptions by about half. * Second, for the first ftire, the budget extends the MODVAT coverage to selected services. Specifically, a 5 percent excise tax rate will apply to tel:phone services, the net premium charged by insurance companies on non-life policies, and the brokerage commisions charged by stock brokers. However, the Tax Refonm Conmmittee's recommendations also to tax life insurance premium and advertising services have not been implemented. * nThird, the budget shifted most excise rates from a specific to an ad-valorem, design to increase buoyancy. * Fourth, the reporting for assessment purposes undor the excise tax system will be simplified by relying primarily on invoices for value determination. This is an importam step towards the adoption of a VAT. Personal Income Tax The budget has: * vwithdrawn the 12 percent surcharge on non-corporate income; - Q increased gte zero-tax bracket threshold from Rs. 30,000 to Rs. 35,000 and other bracket levels by 20 percem; * pernitted the self-employed to make deductible contributions to 'pension' or IRA type funds to be established by the Unit Trust of India; - *3 maintained presumptive taxation of those in the unorganized sector; in addition, unincorporatd contractors with tumnover below Rs. 4 million and truck-owners will be taxed by a presumptive tax equal to 8 percent of gross receipts. Company Income Tax The budget has: * unified corporate tax rate a, 40 percent. the previous system taxed widely-bald companies at 45 percent and other dmetic companies (closely-held) at 50 percen; thle 15 percent surax on corporate incownes above Rs.75,000 has been retained; ience, the post-budget, top marginal rate on corporate income is 46 percent. which compares to a top personal rate of 40 percent; * reduced to 55 percent from 65 percent the tax rate on foreign-based branches; * reduced to 30 percent from 40 percent the rate of tax on capital gains tealized by domestic companies; this measure is intended to pardy overcome the 'lock-in effect and thereby *assist Indian companies to re-stacturw themselves to improve their competitive position in the market;' unit shares in the Unit Trust of India and other mutual funds wil attact the 20 percent long-term capital gains rate, if held for 12 months or more rather a 36 month or more holding period as previously required; * reduced to 20 percent from 25 percent the rate of withholding tax on interest and dividends paid to non-resident individuals and companies. disease control, and maternal and child healtn programs. The 1994-95 Budget has further increased the allocation for such programs with a view to expanding the provision of key social services in areas with a high incidence of poverty; in the same vein, the allocation for rural  -30 - employment and related programs has been increased by over 50 percent and now accounts for 0.5 percent of GDP. Fwsad Adjustment 1.40 The fiscal deficit target for 1994-95 is 6 percent of GDP. The 1.3 percentage points of GDP fiscal correction for 1994-95 is to come entirely through expenditure contraction which is to be achieved mainly through reduced spending on subsidies, defense, loans and grants to states, and loans to public enterprises (Table 1.1). Decisions taken early in February 1994 to raise the price at which rice and wheat are sold through the Public Distribution System should help contain the cost of subsidies ' ithin the budget amount--delay in taking such decisions was the main cause for the 1993 -94 budget overrun on account of subsidies. However, no decision has yet been taken to raise the price of fertilizers, and without such an increase it would not be possible to contain the cost of the subsidy within the budget limit. Togeth'r with a recovery of manufacturing growth and imports, improvements in tax policies which have made it possible to improve tax administration are expected to offset the decline in customs, income taxes and excise rates and so maintain revenue in terms of GDP constant in relation to 1993-94. While the target of 6 percent of GDP for 1994-95 is modest compared with the 4.7 percent of GDP target for 1993-94, and implies only partial correction of the fiscal overrun in that year, its achievement may require additional and timely expenditure and revenue measures as the year unfolds (para. 1.45). 1.41 The Government fully recognizes the necessity of strengthening central government finances, both quantitatively and qualitatively. The RBI's most recent annual report expresses alarm on the modest progress achieved in reducing the fiscal deficit since 1991. The Ministry of Finance's most recent Economic Survey (February 1994) indicates that "it is vital to reassert control over the fiscal situation to curb inflation, reduce interest rates, release resources for productive investment and sustain confidence in the econonty"; highlights the need to reduce subsidies and improve their targeting; and reiterates a recommendation already in the Eighth Plan to prioritize public expenditure through zero-based budgeting procedures. Yet, with revenues unlikely to increase (because further reductions of tariffs on imports are envisaged) and government discretion over its expenditure limited to a small proportion of that expenditure, a concrete and pragmatic medium-term strategy to reduce the central government fiscal deficit has yet to evolve--and will have to involve rethinking of the current system of intergovernmental transfers. 1.42 Three considerations have led the govermnent to limit the extent of fiscal deficit reduction in 1994-95 and set a fiscal deficit target higher than in the previous fiscal year. First, more than their two predecessors, the last two budgets accommodate the considerable fiscal cost of the reform process underway. For example, on the expenditure side, the liberalization of interest rates has increased interest costs on the central government debt from 4 percent of GDP in 1990- 91 to 5.1 percent of GEI anticipated in 1994-95 (even though the stock of central government debt in relation to GDP has remained relatively constant, Table 1.3). On the revenue side, tariff reductions have brought customs collections down from 3.9 percent of GDP in 1990-91 to 2.8  -31- percent of GDP ir. 1993-94 (15 percent of this decline is accounted for by a decline in imports and 85 percent by the decline in tariffs). The decision taken in June 1993 to shift from the RBI to the Central Government the costs of the exchange rate guarantees extended on foreign currency deposits (NRIs, para. 1.53) has eliminated the major source of the RBI quasi-fiscal deficit, but has correspondingly added half of 0.1 percent of GDP to the 1994-95 fiscal deficit. The cost of the National Renewal Fund (NRF, para 2.20) has amounted to, 0.1 percent of GDP in 1993-94 and an equivalent amount is budgeted for 1994-95. The devaluation has considerably increased the cost of subsidies--in spite of increases in prices their cost has continued to escalate. 1.43 Second, the 1994-95 budget highlights the central government's limited discretion in controlling its expenditure in the short run. Of total expenditure of 16.8 percent of GDP budgeted for 1994-95, 79 percent is accounted by interest payments (31 percent), defense (15 percent), wages (10 percent), and grants and loans to the states (23 percent, most of which are mandated by the Constitution, Box 1.7). It also highlights the need to shift to the states a larger proportion of the burden of the fiscal adjustment--the states' deficit has remained constant over the last three years at about 3 percent of GDP. 1.44 Third, as indicated in the Minister of Finance's Budget Speech, the government takes the view that the short-term macroeconomic consequences of the fiscal slippage in 1993-94 and of the partial correction envisaged for 1994-95 are unlikely to be severe and that a stronger recovery is needed to prevent a further deterioration of public finances. In 1993-94, the current account deficit of the balance of payments declined to 0.3 percent of GDP. At US$15 billion, reserves are at their highest level ever. Food stocks account for another US$5 billion. Significant capacity underutilization is widespread in manufacturing. A significant part of inflation has been caused, on the supply side, by increases in administered prices and agricultural prices catching up with their international equivalents and, on the demand side, by the surge in capital inflows resulting in an expansion in monetary aggregates which has put pressure on commodity prices. The government has thus given priority to stimulating investment through the introduction of key structural reforms. This has been done with the expectation that, with more income-elastic sources of taxation now in place, a recovery of growth would improve tax collections, and thus increases in tax revenues would play a larger role in fiscal consolidation in the future. It should be clearly recognized, however, that continued high fiscal deficits pose the most single threat to the attainment of India's development objectives. 1.45 A key question about the 1994-95 budget is whether it will be successful in stimulating private investment. While the budget has reduced the user cost of capital, what is ho!ding private investment back may not be so much high user cost of capital, as the significant idle capacity in sectors where private investment can now most easily flow in (e.g., manufacturing); meanwhile in sectors where there is an urgent need to expand capacity, a policy and institutional framework supportive of private investment is not yet in place, and barriers to entry have not yet been entirely removed. To reach its reactivation objectives, it is thus urgent that the 1994-95 Budget be complemented by sector-level reforms addressing remaining policy constraints deterring private investment in key sectors of the economy (paras. 1.21-1.27). Even if these measures are implemented rapidly, however, the recovery of the economy may take longer than  - 32 - anticipated by the govermnent. Thus, in the course of the current fiscal year, additional resource miobilization measures (such as acceleration of privatization) or further expenditure cuts may become necessary to ensure that the 1994-95 fiscal deficit target is met and inflationary expectations are dampened. E. Adjustment in State Finance 1.46 At around 16 percent of GDP in recent years, India's 25 state governments are responsible for a large share of the country's public spending. Whereas the states specialize in the provision of a variety of social (education, health, welfare programs such as employment schemes or social security) and economic services (irrigation, agricultural research and extension, rural development, urban development, urban transport, and water supply), the central government specializes in the provision of pure public goods (defense, publik. administration), basic infrastructure (railways, telecommunications, roads), special social progi-anis (for education, health and poverty), subsidies, and lending to public enterprises. Table 1.20: Central Goveniumtn Transfers to High and Low Income States, 1992-93 Own Resources Resourmes from the Center Tax Non-Tax Devolnio Grants Loa Oths Total of Taxes High Income States % of total expenditure 44 10 13 11 15 6 100 % of Central Gvt transfers - - 67 55 42 - 45 Low Income States % of staes' total expendiure 25 13 21 21 14 6 100 % of CenGalGYL transfers - - 32 51 56 - 55 Note; High income states are those whose per capita income is higher than the average per capita income of all 25 swes. They are (ion, Punjab, Hatyana, Mahaashtra, Gajuat, Sildim, Anmachal Padesh. Himachal Pradesh, Tanil Nadu. Karnataka. Nagaland, West Bengal, Andhra Pradesh. These 13 states account for half of India's population. Source: RBI and Bank staff estimates. 1.47 In most federated countries such as Brazil or Canada, the central government channels relatively large amounts of resources to the states to (i) ensure some equity in the provision of key economic and social services across states. and (ii) compensate for mismatches between the revenue-raising ability and fiscal needs of different states. However, while in Brazil and Canada, the states mobilize resources accounting for about 80 percent of their expenditure, the corresponding figure in India is 45 percent. This transfer of resources which takes place through several channels (Box 1.7), has been particularly important for the poorest states; it accounted for 62 percent of their spending in 1992-93 (46 percent in the case of the richest states, Table 1.20). However, transfers to the poorest states account for 55 percent of total central government resources channelled to the states-the remaining 45 percent was channelled to the  - 33 - Box 1.7: Transfers of Resourcesfrom the Cenral to the Sae Governments The Indian central govemnment transfers resources to the states through several channels. S First, according to the Indian Constition, the States are entitled to a share of central government collections of personal income taxes on non-agticultural income (taxation of agricultural income is the prerogative of the States), and excises. The Finance Conmmission onmtated every five years by the President of India fixes the proportion of collections devolved to the States (currently 80 percent of personal income iax and 45 percent of excise) for a five-year period, as well as the formula for distributing these taxes among States-which give a strong weight to indicators of needs such as population, and income disparities and very little weigbt to indicators of fiscal perfomiance. * Se the Finance Comnission also deternines under Article 275 of the Constitution annual non-Plan grants to the States to compensa for imbalances in their taxable capacity and ensure some equity across States regarding provision of public goods and services. * Third, each state government is entitled to borow from the central govermrent up to 75 percent of the increase in deposits in Small Savings Schemes in that state. Since it is the central government who fixes interest rates and tax incentives applied to these schemes. the states have no discretion to mobilize additional resources from this source. * Fout1, the central government pTovides financial assistance (generally to 70 percent loans and 30 percent grants) to help the staes finance their state plans. As is the case of the cental govermment. each state has an evolving a list of programs and investment ptojects which once approved by the Planning Comnmission (a standing commission chaired by the Prime Minister) becomes part of the country's five-year plans. Every year, allocation of centrai government support for the states' plan is the subject of intensive discussions between the Minustry of Finance, the Planning Commission. and the state governments. Although the cenntl govenument has discretion on the total anual assistance to state plans, the distribution among states is determined by a formula (the Gadgil formula) which, as the tax-sbaring formulas, gives primary importance to indicators of needs. * Efj. a number of national programs are formulated and designed by the central goverunent, and implemented in collaboration with the states and are counted as part of state expenditure-the so-called centrally-sponsored plan programs. Examples of such progrms include close to 200 crop development programs aimed at encouraging the diffusion of crop-specific technologies and fminmhg methods; the Family Welfare Program which provides family planning and health services; the Integrated Cluld Development Services, which employs 500,000 social workers to provide a package of basic health, nutrition, and preschool education services to children up to age six and to pregnant and lactating mothers in roughly 2,200 out of the total of 5,500 rural blocks in India (blocks are geographic areas with around I 10,000 people); and employment programs such as the Jawahar Rozgar Yabana. Total anual funding is determined by the central govemment, and the distributon among states is generally according to scheme-specific criteria also set by the center (but generaUly with a high weight for population and poverty indicators). While many of these prgrams such as the Family Wetfare Program and the Integrated Child Development Services are fully funded by the central goverment, some have matching requirements varying between 50-80 percent. * Sixth, the central govemment also controls the states' main other sources of borrowing: (i) the so-called "market loans' which are long-term state securities which the authorities have sanctioned as eligible for banks' SLR; (ii) loans negotiated witb public financing isitutions such as th_ national Cooperative Development Coiporation and the National Bank for Agriculture and Rural Development; (iii) in coordination with the RBI, the central government decides on the limits for state borrowing from non-bank funancial insttions such as the Life Insurance Corporation of India, and state provident funds, and overdrafts from the RBI. richest states which, in theory, should be able to increase their tax effort or resort to domestic capital markets without the intermediation of the central government. 1.48 Fiscal problems at the level of the states started in the early 1980s, with an unsustainable increase in current spending (which in terms of GDP has risen from 11 percent in the early 1980s to 13-14 percent in recent years) without a corresponding effort to mobilize additional resources. In addition, over the 1970s and 1980s the states have invested vast resources in the development of state level infrastructure in rural and urban areas (irrigation, bus transport, power facilities, schools and health facilities) without putting in place the financial mechanisms  - 34 - that would permit cost recovery sufficient to maintain the assets and help finance further accumulation. As indicated earlier, the cost of subsidies provided by the State Electricity Boards has exceeded 1 percent of GDP in recent years. Losses of the State Transport Boards have been at around 0.5 percent of GDP. The Eighth Plan documents estimate that the cost of low user charges for the economic services provided by the states (irrigation, urban services, water supply, bus transport) amounts to several percentage points of GDP. 1.49 Since the mid-1980s, the deterioration of the states' finances has affected the provision of key social and economic services (Table 1.21). Spending on water supply and sanitation has declined in real terms starting in 1988-89; spending on irrigation has declined in real terns starting in 1989-90; growth of spending on transport and housing was already negative in the mid-1980s. Some of this contraction in spending has had beneficial effects. In the case of bus transport, it has led to an increasingly favorable attitude towards licensing private bus operators, with the result that, at the national level, the share of public buses in the total declined from 46 percent of the national fleet in 1980-81 to 33 percent of the fleet in 1989-90. In the case of irrigation, it has encouraged a shift from public canal irrigation to private tube wells and low- lift PUMpS. Box 1.8: Fscal AJwoie In Seec Swas ldi's saes at very differt levels of economic and social development; their tax effort varies considerably (from a high 12 percent of the state national product in Tanil Nadu to a low 6 pertcm in Uttar Pradesh and 5 percent in Bihar). and they have very different administrtive capactes. Responses to tiese fiscal trends have tbus varied from sta to state. Tamil Nadu, for instance, bas sucessfilly prtctd social spending by inobiding additional tax evenues (the sates' tax sevenues increased 4 percent in real trms in 1991-92 and another 2 prcnent In 1992-93); taking steps to increase user charges; and puti a cap on the agricltual power subsidy. Orissa, one of the least developed sts in India and one extremely dependent on central goverment assistae (it accounts for 60 percent of the states' total revenue compared to only 25 percent i Tamil N adN has lng suffed fm weak public finances- wih a gowuig wage bill, and mountg subsidies to te power sector. A 50 percet decline in small savings collections in 1991-92 created a serious fiscal problem which the stae addressed by: (i) cuig capita eding; ad (ii) e