India - Structural Adjustment Loan/Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15774 PERFORMANCE AUDIT REPORT INDIA STRUCTURAL ADJUSTMENT LOAN/CREDIT (Loan 3421-IN; Credits 2316-0-IN and 2316-1-IN) June 19, 1996 Operations Evaluation Department This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Currency Equivalents (annual averages) (Currency Unit = Rupee) 1990 US$1.00 Rs. 17.504 1991 US$1.00 Rs. 22.742 1992 US$1.00 Rs. 25.918 1993 US$1.00 Rs. 30.493 1994 US$1.00 Rs. 31.374 1995 (September) US$1.00 Rs. 33.263 Abbreviations and Acronyms CAS Country Assistance Strategy CEM Country Economic Memorandum ESW Economic and sector work IBRD International Bank for Reconstruction and Development ID Institutional Development IDA International Development Association IMF International Monetary Fund MOUs Memoranda of Understandings OED Operations Evaluation Department PAR Performance Audit Report PCR Project Completion Report PE Public Enterprise QRs Quantitative restrictions SAL Structural Adjustment Loan SAP Structural Adjustment Program SEBs State Electricity Boards SECAL Sector Adjustment Loan WDR World Development Report Fiscal Year April 1 - March 31 FOR OFFICIAL USE ONLY The World Bank Washington, D.C 20433 U S A. Office of the Director-General Operations Evaluation June 19, 1996 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on India - Structural Adjustment Loan/Credit (Loan 3421-IN; Credits 2316-0-IN and 2316-1-IN) Attached is the Performance Audit Report (PAR) for the India Structural Adjustment Operation (Loan 3421-IN/Credits 2316-0-IN and 2316-1-IN). This US$500 million loan/credit was approved in December 1991 and closed on schedule in December 1992. This operation was the Bank's first adjustment loan/credit to India. Its main objectives were to: (i) help India cope with a balance of payments crisis of unprecedented severity; and (ii) support a broad-based set of policy reforms aimed mainly at liberalizing the Indian economy and opening it up to more competition both from within and abroad. Complementary stabilization policies were undertaken simultaneously under an IMF program. Further structural reforms were supported by two subsequent adjustment operations: the Social Safety Net Sector Adjustment Credit (FY93) and the External Sector and Investment Loan (also FY93). This PAR finds that the operation's objectives were timely and relevant, and it agrees with the Project Completion Report (PCR) that implementation was satisfactory in most respects. The timely provision of foreign exchange in combination with other official capital that the operation helped to catalyze, enabled India weather its balance of payments crisis and improve its creditworthiness. On the policy side, the pace and scope of reforms exceeded the operation targets in several key areas, viz., exchange rate policy, liberalization of the import regime, and financial sector reform. In other areas, however, progress was more gradual (exit policy for industrial firms, removal of restrictions on agricultural exports). In the case of public enterprise reform, progress has been considerably short of what was envisaged. The PAR agrees with the PCR's ratings of the operation's outcome as satisfactory and institutional development (ID) impact as substantial. In contrast to the PCR, however, the PAR rates sustainability as uncertain because-notwithstanding encouraging progress on the liberalization front- there have been insufficient fiscal reforms at both the central and state government levels and inadequate public enterprise and institutional reforms to ensure continued economic growth and poverty alleviation in the future. These shortcomings are reflected in declining public savings, an onerous debt burden, and a crowding out of public and private investment by public sector current expenditure, which may endanger the sustainability of the achievements so far, in terms of growth rates, foreign investment and general dynamism of the economy. In commenting on the draft PAR, the Government of India expressed its "reservations" about the sustainability rating and reaffirmed its commitment to continue with the reform process, but this rating was left as uncertain in the final PAR. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. 2 One lesson flagged in the PCR was that India's initial success in reducing its fiscal deficit was instrumental in enabling it to undertake reforms in trade, finance and public enterprises, and in restoring the credibility and confidence needed to stimulate private investment. A complementary lesson identified in the PAR is that, by the same token, sustainability of the progress is threatened by the recent weakening of fiscal performance. The PAR also finds that the Bank's ability to support the Government reform program was helped by good economic and sector work undertaken by the Bank over many years, and by good mutual understanding of the nature of the problems to be solved. Attachment Contents FOR OFFIClAL USE ONLY Preface.. 3............3 Basic Data Sheet... ......... 5 Evaluation Summary .................................................... 7 1. Introduction and Background ..................................... ..... 13 PAR vs. PCR Coverage: What Value Added from the PAR?......... ...................13 PAR vs. PCR Ratings: Differences .................................... 14 Background .................................................... 14 Bank/India Relationship ............................................ 15 2. SAL Objectives and Design: Evaluation of Relevance ................. 17 Unfolding of the 1989-91 Crisis ........................... .............. 17 The Bank Strategy ....................................... ......... 18 Reform Program of the New (June 199 1) Government .................. 19 SAL Objectives and Components..................................... 20 Evaluation of the Project's "Relevance" .................................20 Ownership and Congruence: Very High ................................ 20 Adequate Diagnosis Based on Satisfactory ESW? Yes...................21 Clarity of Objectives and Appropriateness of Priorities: Mixed .... .............22 Timeliness and Appropriate Mix of Instruments: Very Good ...... .......... 23 Adequacy of the Financing Provided: Sufficient ................... 24 Adequacy of the Risk Assessment: Weak.............................. 24 Relevance: Overview .................................... .........25 3. SAL Implementation: Evaluation of Efficacy.....................27 Actual vs. Planned Implementation of Policy Reform. .......................27 Actual vs. Projected Outcomes........................................29 Balance of Payments Outcome.......................................30 Social Costs of Adjustment.........................................31 Efficacy Overview...............................................33 Outcome and Institutional Development Ratings...................33 Borrower Performance on Implementation...............................34 Bank Performance in Supervision..................................... 34 This report was prepared by Robert Armstrong (Task Manager) and Gopi Arora (Consultant) who audited the project in April 1995. Norma Namisato provided administrative support. The report was issued by the Country Policy, Industry, and Finance Division (Manuel Pefialver, Chief) of the Operations Evaluation Department (Francisco Aguirre-Sacasa, Director). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed widhout World Bank authoriz3tion. 2 4. The Unfinished Agenda and Sustainability Issues........................ 35 Stabilization and Public Savings......................................35 The Revenue Deficit and Public Debt.................. ................36 Insufficient Public Enterprise Reform...................................37 Labor Market Issues ..............................................38 Infrastructure: A Key Constraint to Future Growth.........................39 Social Sector and Poverty Issues...................... ................40 A Core Set of "Sustainability Indicators"................................42 Sustainability Rating.............................................. 43 5. Main Findings and Lessons........................................ 45 Main Findings................................................... 45 Main Lessons................................................... 45 The Centrality of Stabilization....................................... 46 The Importance of Country Conditions ........................ ......... 47 Annexes I. Policy Matrix......................................................49 II. Letter from the Government of India commenting on the draft PAR ............. 59 3 Preface This is a Performance Audit Report (PAR) on the Structural Adjustment Loan and Credit (SAL) for an amount of US$500 million. The SAL was approved in December 1991 and closed on schedule in December 1992, having been fully disbursed. The PAR is based on the Project Completion Report (PCR) prepared by the South Asia Regional Office and issued in June 1995, the President's Report for the project, the legal documents, a summary of the Board discussion, project files, related economic and sector work, and discussions with Bank and IMF staff. An OED mission visited India in April 1995 and discussed the effectiveness of the Bank's assistance with public sector officials, donor representatives, members of the business community, and others in the private sector. Their kind cooperation and invaluable assistance in the preparation of this report is gratefully acknowledged. The draft PAR was sent to the Borrower for comments. The comments received from the Ministry of Finance are reproduced as Annex II. r 5 Basic Data Sheet STRUCTURAL ADJUSTMENT LoAN/CREDIT (LOAN 3421-IN/CREDrs 2316-0-IN AND 2316-1-IN) Credit Position (Amounts in US$ million) As of May 31, 1995 Ln./Cr. Original Disbursed' Canceled Repaid OutstandingO L3421 250 250 - 250 C2316-0 220 226 - 254 C2316-1 30 33 - 36 Cumulative Estimated and Actual Disbursementsa 1991 1992 Appraisal Estimate 300 500 Actual 300 500 Actual as & of Estimate 100 100 Project Dates Planned Revised Actual Appraisal Mission 09/30/91 09/27/91 09/27/91 Negotiations 10/30/91 10/28/91 10/28/91 President's Rpt. - 11/12/91 11/12/91 Letter of Dev Policy - 11/11/91 11/11/91 Board Approval 12/05/91 12/05/91 12/05/91 Signature 12/05/91 12/05/91 12/05/91 Effectiveness 12/30/91 03/04/91 12/11/91 Closing 12/31/92 12/31/92 12/31/92 Completion 06/30/93 06/30/93 06/30/93 a. Disbursed and outstanding amounts differ from the original amount of the credit in terms of US$ because of changes in the US$/SDR exchange rate. 6 Staff Inputs (staff weeks) Total (up to FY93) Preappraisal 55.3 Appraisal 27.5 Negotiations 15.4 Supervision 25.0 Others 0.3 Mission Data Month/Year No. weeks No. Staff weeks Date of Report persons Preparation 07-08/91 2 4 8 09/06/91 (IM) Appraisal 09-10/91 2 5 10 11/12/91 (PR) Supervision 1 01/92 1 2 2 02/13/92 Supervision II 05/92 1 4 4 06/18/92 Completion n.a. 06/30/93 Other Project Data (Borrower: Government of India) Follow-on Operations Ln/Cr No. Amount Board Date (US$M) Social Safety Net Sector Adj. C2448-IN 500 12/17/92 External Sector and Investment L3627-IN 300 06/24/93 7 Evaluation Summary Background 1. The India SAL was a major event in the evolution of Bank/India relations. It was a culmination of many economic and sectoral studies produced and discussed over the years, of many aid consortium meetings chaired by the Bank, of many interactions with the IMF, and of many efforts to foster a productive dialogue concerning India's economic development strategy. 2. From independence, India pursued a planned, interventionist approach to development combining an active role for the state in key sectors with extensive regulation. Capital scarcity was perceived to be the binding constraint to India's growth, and policy focused on building the capital stock, particularly in industry. Detailed Five-Year Plans were a principal instrument of economic management, and high tariff walls and quantitative restrictions (QRs) were installed to protect the infant industries. India's trade policy was essentially inward-looking and autarkic, and by discriminating against labor-intensive exports had adverse effects on income distribution and poverty. 3. On the whole, conservative macroeconomic (stabilization) policies prevented (until the late 1980s) the emergence or persistence of fiscal and balance of payments imbalances, and thus prevented serious debt-servicing problems from arising and kept inflation low. There was, moreover, some beginning of reform in the 1980s that led to freer entry by private sector agents and some reduction in price controls. In 1984, Rajiv Gandhi assumed office following Mrs. Gandhi's assassination, bringing a fresh promise of market-oriented reforms. But his Government's modest reforms (in terms of liberalization) were partial and piecemeal. 4. Adjustment lending did not happen in India until the SAL of 1991 for two basic reasons. One was that there was no pressing need, until the crisis period of 1989-91, for quick-disbursing assistance. But even if there had been a more pressing balance of payments justification, adjustment lending would have been prevented by the fact that the Bank/India policy dialogue regarding the main structural adjustment issues (mainly the role of the state vis-j- vis the private sector, and the extent of state control and regulation) was not sufficiently fruitful. Project Design and Relevance 5. The growth path of the 1980s was not sustainable because it was fueled by increasing public expenditure financed by large internal and external borrowing. But political changes and uncertainties, including domestic unrest in several parts of the country during the 1989-91 period, prevented the Government from pursuing the needed stabilization and adjustment measures. In this context, the Gulf crisis beginning in August 1990 compounded what was already a volatile situation. By 1991, the country faced a financial crisis and was on the brink of default. 6. As the crisis unfolded, the Bank's strategy shifted, to give highest priority to "supporting India's efforts to restore macroeconomic equilibrium, accelerate structural reforms (especially in the areas of industry, trade, finance and public enterprises), and helping India regain access to private credit markets." In other words, the new strategy gave priority to stabilization (especially 8 reduction in the fiscal deficit) and structural adjustment. The new 3ank strategy was first discussed with the Government in early 1991, but the SAL was able to become a reality only because, in mid-1991, the new government that took office was fully committed to launching a comprehensive and far-reaching reform program. 7. The SAL had two basic objectives: (i) to help India deal with its immediate balance of payments crisis by providing US$500 million in quick-disbursing funds; and (ii) to support the initial phase of the Government's program of macroeconomic stabilization and structural reform. 8. The reforms focused on fiscal adjustment; deregulation of domestic industry and promotion of foreign direct investment; liberalization of the trade regime; financial sector reform (of domestic interest rates coupled with measures to strengthen capital markets and institutions); and initiation of public enterprise reform. There were no explicit prior conditions for appraisal, negotiation or Board approval. The substantial set of measures adopted between June and December 1991 were deemed to be "prior actions," sufficient to warrant the SAL's first tranche of US$250 million. 9. The SAL was well founded in good analytical work and well grounded in a long- standing relationship and dialogue between Bank staff and India. The SAL/SAP program was strongly owned by the Government, and there was high congruence between the reform strategy advocated by the Bank and the one adopted by the Government. The sequencing of the program was suited to the Indian political economy, and the Bank was appreciative of the political and institutional realities of the country. 10. The process of building the dialogue in a low key, low profile manner over time was well managed. Technically, the program was well conceived in dealing first with the most egregious distortions and most binding constraints. The stabilization and adjustment components were on the whole well integrated. Given the constraints to both SAL preparation and aid mobilization prior to June 1991, the Bank responses on these fronts after June 1991 were timely and sufficient. The balance between measures to deal with the short-term balance of payments crisis and those dealing with structural issues was appropriate to the country's circumstances and needs. There was good Bank/IMF collaboration and an effective division of labor and roles between the two institutions. 11. Two (relatively minor) shortcomings of the SAL design and preparation were that the project objectives and conditionalities were (too) numerous and unprioritized, and that there were few well-defined and monitorable performance indicators. Provisions to deal with the social dimensions of adjustments were limited, but these issues were more extensively tackled in a follow-up operation (the Social Safety Net Sector Adjustment Credit, C2448-IN, of FY93). The risk assessment was weak and there was no sensitivity analysis or contingency planning built into the project design. Little attention was given in the project documents to sustainability issues or indicators. 12. On balance, the project was highly relevant. The SAL was the right project at the right time. The process (of building and managing the policy dialogue) was as important as the product. Both Bank and Borrower performance in the design and preparation of the SAL were fully satisfactory. 9 Implementation and Efficacy 13. The agenda of reforms laid out in the Letter of Development Policy and the policy matrix to the SAL (Annex I) was an ambitious one, especially in the context of India's history of only incremental reform. That agenda was nearly fully implemented, within the targeted time frames. This was a remarkable and historic achievement, as the Government showed with its actions and not just its plans that it had "seized the day." 14. There were only three areas of shortfall in compliance with the SAL covenants, viz.: (i) the rate of removal of administrative export controls on selected agricultural products; (ii) the formulation of exit policies for industrial enterprises; and (iii) the initiation of measures to restructure or close unviable public enterprises. Compliance was at least partial, and the Region was justified in proceeding with tranche release notwithstanding these partial shortfalls. These shortfalls, however, while not critical at the time, did serve as early warning indicators that the implementation of reform might be most problematic in the liberalization of agriculture, firm exit policy, and public enterprise reform. 15. The actual outcomes were close to those projected for key macroeconomic variables such as GDP growth, export growth, and savings and investment rates. The growth of imports was substantially greater than was projected, the current account balance over the period was much smaller, and the international reserve accumulation was much larger, than anticipated. This was due to the unexpectedly large surge of foreign investment-most in the form of portfolio investment-that took place in 1993/94 and 1994/95. India's reserve buildup proceeded at a rate of nearly US$1 billion a month over those two years, reaching nearly US$20 billion by end- 1994. 16. Progress on the stabilization front was less than targeted, with the public deficit averaging about two percent more of GDP than planned, and inflation averaging close to 10 percent annually-as compared with the target of 6.5 percent. Consolidated public sector saving has actually declined, and there is cause for concern especially about state-level public finances. 17. Implementation was strong in most areas, including: (i) the initial stabilization effort (although it did not intensify over time as planned); (ii) selected tax reforms and the reduction of subsidies; (iii) quick improvement in the balance of payments (and the "vote of confidence" in the Indian economy reflected in large inflows of foreign investment); (iv) responsible management of these capital inflows (to avoid appreciation in the real exchange rate); (v) trade reforms and deregulation; (vi) an improved investment climate that ensued from these measures (reflected in a rapid rise in investment approvals); (vii) the short duration of the downturn in output and employment, followed by a good export response after the second year; (viii) continued consensus building for reform, including at the state level; and (ix) the apparent avoidance of significant adverse effects on the poor (although the data do not permit conclusive judgments on this matter). The sequencing of reform, and the integration of its parts-particularly the exchange rate and trade reforms-was exemplary. 18. Shortcomings in implementation were linked to those on covenant compliance (para. 14 above). They included: inadequate fiscal discipline (mainly on the expenditure side) beyond the initial stage (at both the central and state levels) leading to high (for India) inflation rate and an excessive burden on monetary policy; slow reform of the large and inefficient public enterprise sector and minimal privatization; a lack of reform in labor legislation; and the lack of an action 10 program to change the roles and improve the performance of the public administration, including through capacity building. 19. On balance, the outcome of SAL is rated as satisfactory. The failure of the Government to pursue deficit reduction and public enterprise reform as vigorously as projected beyond the project period does not detract from the depth and coverage of the reforms introduced nor from the successes achieved in terms of renewed growth and dynamism of the Indian economy. The Unfinished Agenda and Sustainability 20. The progress of reform since the project closed (in December 1992) has been uneven. In areas such as trade policy, investment and tax reform, progress has continued to be impressive whereas in public enterprises, labor markets, agriculture, infrastructure and social services a cautious approach has prevailed. Whether the Government will find the political will to accelerate and intensify reforms in these lagging areas remains to be seen. The words of caution contained in the Government's own 1994/95 Economic Survey regarding the incompleteness of fiscal consolidation and the risks it poses for growth prospects and for external viability suggests that these questions are still standing. 21. The PAR highlights the importance of monitoring a number of sustainability indicators, namely public savings (including at the state level), public investment, the "revenue deficit" (current deficit of the Central Government) and debt burden, public enterprise profits and productivity, labor market efficiency, and human capital development, among others. 22. Political and social forces are pulling in many directions. Growth is continuing at a good pace, yet some social and economic problems are still growing while the fiscal problems progressively narrow the range of options available to policymakers. India's political process showed in 1991 its capacity to come to grips with major economic issues, and the resilience and creativity of this system must not be underestimated. Further policy reforms since 1991 have shown the way forward, and there are many reasons to be optimistic about India's economic prospects, while there is little likelihood of an outright reversal of the reforms. On the other hand, sustainability of the achievements, in terms of growth rates, foreign investment, and general dynamism of the economy, will depend on the pace and intensity with which the unfinished agenda is addressed, which are now uncertain. Hence the rating of "uncertain" for sustainability. 23. The Government's main substantive comment (see Annex II), upon a draft of this report, was to reaffirm its commitment to continuing with the reform process, and it expressed "reservations" about the sustainability rating of "uncertain." It is certainly very encouraging that the Government considers the reform process to be "irreversible," but OED still finds it appropriate to rate sustainability as uncertain at this time. Summary of Main Findings and Lessons 24. The main findings of this PAR are: (i) that the SAL was the right project at the right time; 11 (ii) that project preparation was a long-term process that spanned many years of application of all the Bank's instruments; (iii) that the role played by the Bank in helping India prepare the SAL-supported reform program took into account national sensitivities about that role, and was much more effective that would otherwise have been the case; and (iv) that whereas a major strength of the 1991 reform program was the integration of the stabilization and structural reform components, the re-emerging fiscal deficits-both in the Central Government and in the states-pose a major threat to sustainability. 25. The main substantive lesson from the review of the SAL experience is the reaffirmation of the centrality of macroeconomic stabilization for sustainability 26. The above findings translate into a number of "process" lessons. These lessons are that the effectiveness and quality of Bank assistance in structural adjustment depend on: * the Bank's willingness and ability to move swiftly and opportunistically to respond to crises (that may offer windows of opportunity to take bold steps); * the mutual understanding between the Bank and the Government about the nature of the problems to be solved, and mutual respect and credibility between the people directly involved in the Bank and the country; * the credibility of the Bank vis-j-vis other donors and creditors (earned through the leadership of the aid consortium, discussion of ESW studies, etc.); * good understandings by Bank staff and management of the country's capabilities and limitations to implement various types of reforms; * good working relations with the IMF that reflect the needs for well-defined divisions of responsibility and also joint focus on issues such as trade and fiscal reforms; * a sensitivity by Bank staff and management to factors that make countries sensitive both to the reality and appearances of roles played by the Bank; * adequate dissemination of Bank studies and discussion of policy issues, tailored to the country's governance conditions; and * the extent to which key sustainability issues are addressed up front, in the design stage.  13 1. Introduction and Background PAR vs. PCR Coverage: What Value Added from the PAR? 1.1 The coverage of this PAR differs significantly from that of the PCR. This PAR is "self- standing" in that it describes the project's context, assesses the relevance of its objectives and appropriateness of its design, evaluates its implementation, outcome, and sustainability, and identifies some lessons of experience. But since the PCR provided a satisfactory description of the project's objectives and main outcomes, the PAR is relatively brief in covering those areas. Where the PAR findings or conclusions differ significantly from those of the PCR, these differences are flagged and explained. 1.2 One major difference between the PCR and PAR is that the PCR reviewed post-SAL developments in India only through March 1993, 15 months following closure of the project in December 1992, whereas the PAR's review extends through FY94-95 (ending March 31, 1995). This gives the PAR a longer time perspective in which to make judgments about the project's impact, outcomes, and sustainability. 1.3 Another major difference between the PCR and PAR is that the PAR gives especial attention to sustainability. This entails that the PAR focuses on related issues not much touched upon in the PCR, such as the social costs of adjustment, the size and nature of the unfinished agenda of adjustment, and the extent to which there is a social and political consensus in favor of moving ahead with further reforms. Hence, Chapter 4 constitutes an assessment of the unfinished agenda and sustainability issues. 1.4 Other ways in which the PAR differs from the PCR is that this PAR (i) identifies (as the PCR did not) how the actual outcomes compare with the anticipated/projected outcomes, and explains the differences; (ii) identifies more explicitly than the PCR the project's main strengths and successes vis-a-vis its main weaknesses and shortcomings; and (iii) provides some forward- looking lessons. The PCR was drafted in the first half of 1993 but was not finalized and sent to the Board until June 1995. The reason for this delay was that OED and the South Asia Region agreed that it would be important to have a government- prepared Part II for the SAL. The Government agreed to prepare Part 1l but never did. OED and the Region finally agreed in early 1995 to send the PCR to the Board without a Part 11. 14 PAR vs. PCR Ratings: Differences 1.5 The following table compares the project ratings as assigned by the PAR and PCR. PCR PAR Outcome Satisfactory Satisfactory Institutional Development Substantial Substantial Sustainability Likely Uncertain Bank Performance n.a. Satisfactory Borrower Performance n.a. Satisfactory n.a.: not available 1.6 The only difference in ratings is that the PAR is less sanguine than the PCR about sustainability. The PCR, written in mid-1993, reflected the (then) highly bullish outlook of the Government, donors, the Indian stock market, and most other observers, following the many positive developments that had occurred in the 18 months between SAL approval and PCR preparation. By the same token, the somewhat more guarded outlook of the PAR, written two years later, takes into account the more recent loss of momentum by the Government in achieving its initial stabilization objectives and in addressing its still large unfinished agenda of adjustment, particularly in terms of downsizing the public sector. The distinction is mainly in terms of the relative emphasis given in this PAR to "causes for concern" that were neither identified nor addressed in the PCR. 1.7 The PCR did not provide explicit ratings of either Bank or Borrower performance. Had such ratings been provided, however, they would have been in agreement with the PAR ratings of satisfactory on both sides. 1.8 The PCR did not explicit address the matter of the SAL's ID impact and the above rating is inferred. But the PAR finds that the ID impact was indeed substantial when ID is defined broadly as changes in the "rules of the game" that make for a better-functioning economy. If ID were defined more narrowly in terms of organizational changes and capacity building making for a more streamlined and efficient public sector, then the ID rating would be more in the range of "modest." This distinction is discussed more fully in Chapter 3. Background 1.9 The SAL was a major event in the evolution of Bank/India relations. It was a culmination of many economic and sectoral studies produced and discussed over the years, of many aid consortium meetings chaired by the Bank, of many interactions with the IMF, and of many efforts to foster a productive dialogue concerning India's economic development strategy. 1.10 Most importantly, the SAL coincided with and supported a far-reaching set of policy measures taken by the Government. If India does in fact succeed in sustaining and deepening its reforms, as there is good reason to hope, then the events surrounding the SAL will warrant the label of historical turning point. 1.11 The remainder of this chapter provides some background on the evolution of Indian economic policy and the relationship with the Bank. For it is only by appreciating the context 15 that one can address questions such as: What was the impact, if any, of the policy dialogue leading to the SAL? How great was Indian "ownership" of the SAL-supported reforms? Why did it take until 1991 for the Bank to make its first adjustment operation in India? 1.12 From independence, India pursued a planned, interventionist approach to development combining an active role for the state in key sectors with extensive regulation. Capital scarcity was perceived to be the binding constraint to India's growth, and policy focused on building the capital stock, particularly in industry. Detailed Five-Year Plans were a principal instrument of economic management, and high tariff walls and quantitative restrictions (Qrs) were installed to protect the infant industries. India's trade policy was essentially inward-looking and autarkic, and by discriminating against labor-intensive exports had adverse effects on income distribution and poverty. 1.13 On the whole, conservative macroeconomic (stabilization) policies prevented the emergence or persistence of fiscal and balance of payments imbalances, and thus prevented serious debt-servicing problems from arising and kept inflation low. There was, moreover, some beginning of reform in the 1980s that led to freer entry by private sector agents and some reduction in price controls. In 1984, Rajiv Gandhi assumed office following Mrs. Gandhi's assassination, bringing a fresh promise of market-oriented reforms. As Bhagwati has observed, however, the "perceptions ran ahead of the reality," and such modest reforms (in terms of liberalization) as were taken tended to be cautious, partial and piecemeal. 1.14 Nevertheless, during the 1980s India's GDP growth averaged about 5.5 percent while inflation ran about 8 percent, and poverty decreased significantly. These were certainly important achievements. Yet they fell far short of what many of India's neighbors and competitors were achieving, and India's dissatisfaction with its own performance increased accordingly. By the end of the decade growing fiscal imbalances (owing in large part to the drag of the public sector) and other constraints seriously imperiled the sustainability of development. It was in this context that the 1989-91 crisis gave a push to reform, and led to the Bank's first adjustment operation. Bank/India Relationship 1.15 The history of the Bank/India relationship goes back to the beginnings of the Bank itself. IBRD lending began in 1949 and IDA lending began in 1960, upon the creation of IDA. The Indian portfolio is the Bank's largest by number of projects approved (365 projects for US$45 billion as of FY95). The India Aid Consortium, led by the Bank, was established in 1958. The Bank has also on many occasions lent its good offices to finding solutions to problems involving neighbors or other debtors and creditors. The Bank played a crucial role, for example, in fostering the Indus Waters Treaty of 1960. 1.16 The Bank's Resident Mission in New Delhi was opened in 1957, and the many man- years spent by Bank staff in India served to improve the Bank's understanding of India's conditions and culture. By the same token, several of the Indian technocrats responsible for designing the 1991-92 reforms had previously worked in the Bank. The length and breadth of this two-way street will be found to have been important to the realization of the SAL and its positive outcomes to date. 16 1.17 In the early years, the Bank emphasized infrastructure while in the 1970s and 1980s Bank assistance was broadened to include agriculture and the social sectors. Almost all of this lending involved a policy dialogue of some sort, with Bank sectoral studies often constituting significant reference points for that dialogue. But it cannot be said that there was a very fruitful policy dialogue concerning India's fundamental economic strategy. 1.18 Adjustment lending did not happen in India until the SAL of 1991 for two basic reasons. One was that there was not a pressing need, until the crisis period of 1989-91, for quick- disbursing assistance. But even if there had been a more pressing balance of payments justification for adjustment lending prior to 1991, it would have been prevented by the fact that the Bank/India policy dialogue regarding the main structural adjustment issues (mainly the role of the state vis-i-vis the private sector, and the extent of state control and regulation) was not sufficiently fruitful. Notwithstanding that India did in fact implement a limited number of liberalization measures in the 1980s, these by no means constituted a "minimum critical mass" of reforms sufficient to warrant adjustment lending. 1.19 Moreover, there were (and still are in some quarters) strong prejudices within India, both within and outside the Government, against engaging in a serious dialogue with either of the Bretton Woods institutions about structural adjustment, much less accepting Bank/Fund conditionalities that would be construed as politically unacceptable interferences in India's internal affairs. These resistances and reservations stemmed from a combination of ideological preferences (many remained committed to a socialist path) and nationalist sentiments. Many politicians and parts of the press were inclined to severely criticize the Government for entering into a policy dialogue with the Bank. 1.20 Right up to the time of the 1991 SAL, therefore, both Bank staff and government officials had to conduct their dialogue in recognition of these sensitivities. Whether or not Bank staff succeeded in pursuing the dialogue under these conditions with the right "style" and through an appropriate process, as well as with a constructive content, will be an important question addressed in this PAR. 17 2. SAL Objectives and Design: Evaluation of Relevance 2.1 This chapter describes the SAL's objectives and evaluates, with the benefit of hindsight, whether these were the right objectives. This constitutes an assessment of the SAL's relevance. Chapter 3 will subsequently take up the question of whether the SAL's objectives were achieved (the project's efficacy). 2.2 This chapter also constitutes a process evaluation of the upstream stages of the project cycle, i.e. project identification, design, preparation and negotiation. A main lesson that emerges from the findings of the chapter is the importance of the quality of the process. 2.3 In this context, the chapter addresses questions such as: How great was the Government's ownership of the SAL-supported reform program? Was the operation fully consistent with the Bank's country assistance strategy? Was it timely in view of the balance of payments crisis at the time? Did the Bank cooperate effectively with the IMF and other donors? Was adequate account taken of prospective social costs of the adjustment program? Were the upstream processes satisfactory? Unfolding of the 1989-91 Crisis2 2.4 The President's Report on the SAL stated, "the basic policy philosophy shaping [India's] economic growth in the 1980s combined expansionism on the macro side with continued interventionism on the micro side."3 Interventions in the markets for labor, foreign exchange and capital continued to be reflected in serious price distortions, low productivity, and a structural bias against exports. At the same time, the change from the conservative management of aggregate demand of the 1960s and 1970s to fiscal expansionism in the 1980s became reflected in increased trade deficits, debt accumulation, and inflation. 2.5 The growth path of the 1980s was not sustainable insofar as it was fueled by increasing public expenditure financed by unsustainable internal and external borrowing. Yet political changes and uncertainties, in the face of domestic unrest in several parts of the country during the 1989-91 period, prevented the Government from pursuing either the stabilization or adjustment measures needed. By 1991, the country was in crisis and on the brink of default. 2.6 During most of the 1980s, however, and even well into 1989, there had been an upbeat mood regarding India amongst the donors, including the World Bank and IMF.4 This mood changed quickly when, between late 1989 and mid-1991, there were two general elections and four changes of government in a period marked by coalition governments, protests and 2 The overview provided in this section is drawn largely from the PCR and 1994 TIDE as well as from Jalan (1993). World Bank Report No. P-5678-IN, dated November 12, 1991. Bhagwati (1993) refers to the "harvest of goodwill" reaped by both China and India during the 1980s, but he considers that a contributing cause to the perceptions of reform taking place in India "running ahead of the reality" was the World Bank's "influential, optimistic assessments." The Bank, he notes, was eager to find successes. Whether the Bank was culpable of contributing to too much complacency and hence to too little reform action is a hypothesis that this PAR did not attempt to test. 18 breakdowns of law and order in parts of the country, the Gulf crisis (between mid-1990 and early 1991), and the assassination of Rajiv Gandhi in May 1991. 2.7 Some indicators of the impending financial crisis (out of which the SAL was to be borne) are as follows: The overall public sector deficit rose steadily form 7 percent to nearly 11 percent of GDP between 1980/81 and 1990/91. Total domestic public debt increased from 36 percent to 56 percent of GDP while external debt more than tripled to US$70 billion over this period. This was financed through repression of the financial system on the domestic side and increased reliance on shorter-term debt instruments on the external side. A considerable portion of India's borrowing from abroad comprised volatile funding in the form of foreign currency bank deposits from the Indian community living abroad (NRIs). 2.8 The Gulf crisis beginning in August 1990 compounded what was already a volatile situation. The increased oil import bill and losses in foreign exchange receipts caused by the Gulf crisis came at a time when India's creditworthiness was already under strain. Consequently, Indians abroad drew down their foreign currency deposits and commercial banks reduced their exposure. The downrating of India's credit rating by several rating services in the latter part of 1990 and in early 1991 resulted in an effective cutoff of India's access to commercial credit markets. By end 1990, India's foreign exchange reserves had fallen to US$1.2 billion-only about two weeks of imports. 2.9 The additional pressure put on India's balance of payments by the 1990 oil price increases and by the capital flight led to a drastic compression of imports, negotiation of compensatory and standby facilities with the IMF (the latter effective in January 1991), a decision to sell gold, and efforts to mobilize, including through the World Bank, additional sources of official assistance. The Bank Strategy 2.10 As the crisis unfolded, the Bank's strategy shifted to give highest priority to "supporting India's efforts to restore macroeconomic equilibrium, accelerate structural reforms (especially in the areas of industry, trade, finance and public enterprises), and helping India regain access to private credit markets."5 In other words, the new strategy gave priority to stabilization (especially reduction in the fiscal deficit) and structural adjustment. 2.11 The new strategy, discussed with the Government in early 1991, was laid out in the 1991 Country Strategy Paper (CSP), which was endorsed by the President's Council in July 1991. The strategy, subsequently described in broad terms to the Board in December 1991 when the SAL was presented for Board approval, envisaged an annual IBRD/IDA lending program of about US$3 billion, of which about US$1 billion would be policy based lending "with the remainder of the lending program linked to progress towards India's stabilization and reform objectives."6 It was (then) expected that the SAL would be complemented: (i) in FY92 by adjustment operations in support of financial sector reform and a safety net to mitigate the social costs of Quoted from President's Report for the SAL, p. 32 6 Presentation to the Board of the Country Strategy by Mr. H. Vergin, December 5, 1991 19 adjustment; and (ii) in FY93 by adjustment operations in support of trade reform and public enterprise reform. Subsequent SECALs were envisaged in agriculture and in the oil-gas sector. 2.12 Issues flagged for priority in the policy dialogue included fiscal policy; industrial, and trade policy and financial sector reforms; other measures geared to the promotion of private sector development and the attraction of direct foreign investment; public sector enterprise reform; and improvement in the quality and efficiency of social service delivery systems. 2.13 The strategy also called for the Bank to play a major role, including through its leadership of the Aid Consortium, to help mobilize large amounts of "exceptional financing" projected to be needed for the next several years. 2.14 The prospective SAL-together with an associated IMF-supported stabilization program- constituted a "litmus test" of the readiness of the Indian Government to do the necessary in terms of stabilization-cum-structural adjustment. For the Bank itself, the SAL was a trigger in the sense that its satisfactory conclusion would keep India on track to receive some US$3 billion a year from the Bank Group, and would also justify the Bank's continuing with its substantial efforts to mobilize aid from other donors and to turn around the capital flight. On the other hand, a failure to conclude the SAL, or to disburse its second tranche, would trigger a drastic reduction in the Bank's lending program, and would also result in much reduced aid mobilization efforts. 2.15 As of mid-1991, it appeared that India would need well over US$3 billion annually for the next several years, first in order meet the current crisis, and then to restore equilibrium, resume growth, and build up reserves to a more comfortable level. 2.16 These implications were well understood by the Indian authorities. The decision by the Bank to shift to adjustment lending, when first discussed with the Government, in January 1991, had not sat well with the authorities. One main reason was the long-standing aversion to adjustment lending. India was proud that it had never acceded to adjustment lending and its attendant conditionalities. But during the balance-of payments crisis of 1991, it was hard pressed to do so. Fortunately, however, the new government that took office in June 1991 moved quickly to define its own reform comprehensive and robust reform program. As a result, no conditions had to be "imposed." Reform Program of the New (June 1991) Government 2.17 The new (minority) Government moved quickly and forcefully to initiate both stabilization measures and structural reforms. Within the first few weeks the rupee was devalued by 23 percent,7 interest rates were raised, a major fiscal correction was undertaken in the 1991/92 Union Budget (including, for example, sharp cuts in subsidies and transfers to public enterprises), and major initiatives were announced, viz.: the virtual abolition of the complex system of industrial licensing; measures to strengthen competition between the private sector and public enterprises; a liberalization of foreign investment, and reforms in the trade regime. Measured in terms of the rupee cost of the US$. 20 2.18 A significant number of these announced measures were put into effect in the second half of 1991. Particularly notable were the changes in trade policy, aimed at strengthening export incentives and eliminating a substantial proportion of import licensing requirements. 2.19 The members of the new economic team, led by the Minister of Finance, were well known to the Bank on both professional and personal terms, and well respected. This fact, combined with the seriousness of purpose shown be the Government in promptly launching its far-reaching reform program, gave considerable credibility (in the Bank and elsewhere) to the new reform program. As from July 1991, therefore, preparation moved swiftly. A preparation mission took place in August and the project was appraised in September, negotiated in November, and approved in December. SAL Objectives and Components 2.20 The SAL has two basic objectives: (i) to help India deal with its immediate balance of payments crisis by providing US$500 million in quick-disbursing funds; and (ii) to support the initial phase of the Government's program of macroeconomic stabilization and structural reform. 2.21 The reforms were focused on the following areas: fiscal adjustment; deregulation of domestic industry and promotion of foreign direct investment; liberalization of the trade regime; reform of domestic interest rates coupled with measures to strengthen capital markets and institutions; and initiation of public enterprise reform. There were no explicit prior conditions for appraisal, negotiation or Board approval. The substantial set of measures taken and announced between June and December 1991 were deemed to be "prior actions," sufficient to warrant the SAL's first tranche of US$250 million. The additional detailed set of actions defined as conditions for second tranche release (the remaining US$250 million) were described well in the President's Report and PCR and need not be repeated here. Annex I lists both the measures taken prior to Board approval and the second tranche conditions. Following sections of this chapter constitute an evaluation of whether those conditions were appropriate and whether the overall project was "relevant." Evaluation of the Project's "Relevance" 2.22 The main questions to assess relevance are: Were the objectives the "right" ones? Was the amount of financing provided right? And what were the main strengths and weaknesses of the SAL in terms of its design and the processes used to arrive at that design? Ownership and Congruence: Very High 2.23 Indian ownership of the SAL, and more broadly of the reform program supported in its first year by the SAL, was very high. This constitutes one of the project's main strengths, as it was grounded in the Indian Government's own appreciation of what needed to be done, and what could realistically be done, in the context of India's political economy. The rating of the degree of Indian ownership of the SAL is based upon the four-dimensional classification scheme devised by J. Johnson and S. Wasty in their paper entitled Borrower Ownership ofAdjusiment Programs and the Political Economy ofReform (World Bank Discussion Paper 199, May 1993). Their four dimensions comprised; (i) locus of initiative; (ii) level of intellectual conviction among key policymakers; (iii) expression of political will by top 21 2.24 The locus of initiative for formulating and implementing the adjustment program was clearly the borrower's. And the level of intellectual conviction among key policymakers, headed by the new Minister of Finance, was high. There was much debate and disputation in India's democratic, open, parliamentary system regarding both the causes of the crisis and what needed to be done. Building on the groundwork of studies (some contributed by the Bank), debate in the parliament, press and other forums, and consensus building that had gone on for many years prior to 1991, the new government was able, in effect, to take advantage of the need for decisive action to cope with the crisis. 2.25 The importance of the groundwork cannot be overstated. For reform programs that are hatched quickly, without the long preparation, debate and consensus building that characterized the process in India, cannot be owned as fully as was the 1991 SAL/SAP in India. The lesson is that this preparation-most especially in a large and diverse democracy such as India's-cannot be quick and it doesn't come cheap. And to the extent that the Bank seeks to be a significant partner in the preparation process, the costs-in terms of years of doing and discussing quality ESW and doing and discussing policy issues related to Bank-financed projects-are also bound to be high. But as the India case illustrates, the "payoff' to such preparation may be high. 2.26 The "congruence criterion" refers to the extent to which there was congruence between the reform strategy of the Government and the strategy preferred by the Bank. Other things being equal, the more congruent the Bank's preferred strategy for a country and the Government's actual strategy, the more "relevant" is the Bank's strategy in the sense of its probability of implementation. By and large, it may be said that the degree of congruence was large. Some differences in content, pacing and sequencing will however be noted below. Adequate Diagnosis Based on Satisfactory ESW? Yes. 2.27 A necessary condition for designing an appropriate reform program is to have an adequate diagnosis of the economic situation: the binding constraints on growth and poverty alleviation, the most egregious distortions, the root causes of the balance of payments crisis, etc. The Government and the Bank were on the whole well served by a substantial stock of good quality economic and sector studies (ESW) carried out over the years preceding the 1991 crisis. In this regard, the framers of the Indian reform program were in a more favorable position, than their counterparts in many other countries. 2.28 The quality of the Country Economic Memoranda (CEMs) prepared in the few years leading up to 1991 was good, and many Indian commentators inside and outside of the Government cited how useful the Bank's ESW had been, in particular on industry and on trade reform issues. The ESW impact however was not very evident until 1991. In particular, warnings contained in both Bank CEMs and in IMF reports about the unsustainability of the fiscal deficits were not heeded before mid-1991. The ESW that was found most helpful in SAP/SAL preparation was that which (i) provided hard-core empirical studies, e.g on tariff structures and the industrial and financial regulatory systems (as distinguished from those exhorting the principles of sound economic management); and (ii) provided hard information on which policies and practices were proving most and least effective in comparator countries. leadership; and (iv) efforts toward consensus-building among various constituencies. By all four criteria, and especially the first two, the SAL would warrant a high "ownership rating." 22 2.29 Some senior policymakers and advisers noted that the Bank's ESW had also an important role in identifying critical problems and shortcomings in Indian economic performance, in pointing the way to rigorous analysis, and in providing (as in CEMs) a synthetic overview of the economy and its prospects. The impact of this ESW is of course difficult to define and measure. But many Indians across the political spectrum reported that the impact, over time and over many technocrats, was significant. Bank ESW was reported to have been of lesser utility and/or quality in the areas of public enterprise performance, privatization, and poverty. And while some useful study was made of the social costs of adjustment, in time for the subsequent adjustment operation relating to the social safety net, this was not integrated into the design of the SAL. Clarity of Objectives and Appropriateness of Priorities: Mixed 2.30 The SAL warrants high marks for focusing on reforms in the key interrelated areas of trade policy, financial sector reform, industrial policy, public enterprise reform, and private sector development, including the foreign investment regime. The Bank's ESW and policy dialogue helped to demonstrate how binding were the constraints stemming from inappropriate policies in these areas, and the interrelationships among them. Also, the Government was not in the habit of producing comprehensive policy statements such as the "Letter of Development Policy" that constituted the Government's own statement of its reform objectives and priorities, and the SAL played a useful role in catalyzing the production and issuance of such a statement. 2.31 While the reform program was designed and owned by the Indian authorities, the Bank played a catalytic role in stimulating and advancing the policy dialogue amongst the Indian principals. Bank staff and managers took part in many seminars, meetings and private sessions at which they provided information and advice. And while not all this information was used, the Bank is widely credited with its cooperative and active role in "seeing the process [of designing the reform program] through." This process was one that spanned not just the 1991 period of SAL/SAP preparation, but the multiyear process of interaction with technocrats across the political spectrum. 2.32 Two shortcomings of the SAL's design, however, were its large number of conditions to be taken prior to second tranche release (see Annex 1) and its lack of objective and monitorable performance indicators. As of 1991, when the SAL was approved, it was established "best practice" in Bank adjustment operations for the number of conditions to be limited to a relatively small number of important measures.9 A large proportion of the actions to be taken were defined in terms of subjective criteria, for example where actions were required to be "satisfactory to IDA" with no indication, in the project documents, or in side letters, of the criteria to be employed in determining whether particular actions were satisfactory or not. 2.33 The Letter of Development Policy was also lacking in specificity and monitorable targets in some key areas. For example, while the Letter called for the budget deficit to be reduced "substantially" after 1992/93, no target was provided beyond that year. Similarly, the average level of tariff rates was projected to be reduced to that of "other industrializing countries," 9 At the December 5, 1991 Board meeting that approved the SAL, several speakers said that there were too many conditions for release of the second tranche (25 conditions). They said that it was very important to select four or five objectives that were critical to the success of the adjustment program and inform the Government that these would constitute the conditions for tranche release. 23 without specifying the countries or levels. The weakest part of the reform program, both with respect to its design and implementation, was the lack of a robust action program to rationalize and privatize the poorly functioning public enterprises, and to improve the efficiency of the public administration. Timeliness and Appropriate Mix of Instruments: Very Good. 2.34 An important criterion of the SAL's relevance was its timeliness. Given the balance of payments situation in 1991, and the political as well as economic importance of launching the reforms as soon as possible, there was a need for prompt action by the Bank as well as the Government. The action, on both sides, was severely constrained by the political situation until June 1991. But thereafter both the Government and Bank deserve high marks for the timeliness of their follow-up. Five months from preparation mission (August) to Board approval (December) is rapid by Bank standards. 2.35 In addition to the SAL's financial and policy support, the Bank played a major role, together with the IMF, in mobilizing and coordinatin other donors and creditors to help India cope with its crisis and get its reform program going. 2.36 The IMF took the lead in helping India cope with its 1991 balance of payments crisis. There was good cooperation and collaboration between the Bank and Fund regarding their respective efforts both (i) to mobilize the needed financial resources and (ii) to undertake the needed economic and financial analyses and to conduct the policy dialogue. One area where there was some significant difference of views between the institutions was with regard to the pacing of fiscal deficit reduction vis-i-vis tariff cuts. Not surprisingly, the IMF favored more rapid deficit reduction than either the Bank of the Indian Government. 2.37 As the balance of payments crisis evolved in 1991, the Bank and Fund made a considerable number of approaches-both through and outside of the Aid Consortium process-to try to persuade private creditors and official donors to reduce their outflows and/or increase their inflows to India. One instrument was the convening by the Bank of an informal donors' meeting in April 1991. Given the unsettled conditions in India at the time, it is not surprising that there was only very limited success in mobilizing additional resources. Exhortations by top-level Bank managers to commercial bankers similarly had only a very limited effect on stemming the outflow of commercial capital from India at that time. 2.38 By the time of the India Aid Consortium meeting held in Paris in September 1991, however, the atmosphere as well as the objective situation had changed considerably in the light of (i) the Government's decisive measures; (ii) the responses of the Bank and Fund; and (iii) positive responses of several major multinational corporations to India's liberalized foreign investment regime. Several donors indicated interest at the September Consortium meeting in associating their pledged fast-disbursing aid with the SAL, as parallel financing. 10 In 1991, the SAL was just one of several instruments used by the Bank to help India mobilize or conserve foreign exchange. These instruments included also: (i) the fast-disbursing gas project of FY91; (ii) a redeployment of IDA credit cancellations to fast-disbursing adjustment operations; and (iii) the application of disbursement procedures (such as those governing Special Accounts) in ways conducive to accelerating disbursements. 24 Adequacy of the Financing Provided: Sufficient 2.39 The President's Report (PR) for the SAL showed that US$3.7 billion in exceptional financing would be needed, over and above likely inflows of project aid, commercial borrowing, and non-resident Indian (NRI) deposits. This exceptional financing requirement was projected, in the light of the need to rebuild reserves and to service "bunched" debt, to average about US$2.5 billion for the next three years, i.e. through 1994/95. 2.40 As noted above, the IMF was a major source of financing. During calendar year 1991, for example, India made drawings totaling SDR 1.9 billion from the Fund under a first tranche stand-by arrangement and the compensatory and contingency financing facility. Moreover, on October 31, 1991, the IMF Board approved an additional standby credit of SDR 1.7 billion, to be drawn over the succeeding 20 months. This latter standby arrangement, involving upper-tranche conditions, was more important as a means of giving the IMF "seal of approval" to the Indian reform program. 2.41 The Bank's projections of financing requirements turned out to be exaggerated because the volume of portfolio capital inflows into India proved to be far greater than was anticipated. Thus, although internal Bank documents show that some Bank staff were concerned that the program would be underfunded, in the event the program would have been overfunded at the projected levels. Adequacy of the Risk Assessment: Weak. 2.42 The President's Report for the SAL cited three types of downside risks. These were: (i) that social and political reaction to the adverse transitional consequences of adjustment could slow the pace of reform and jeopardize its success (commitment risk); (ii) the slow supply response risk (because of lukewarm private investment or import shortages); and (iii) unforeseeable exogenous shocks (slow growth of world trade, inadequate balance of payments support). The Report however did not discuss how serious these risks were deemed to be in terms of their quantitative implications, say, for the exceptional financing requirement, or the types of social safety net provisions needed. No sensitivity analyses were provided, nor were any contingency measures identified to cope with the risks. 2.43 In the event, the slower-than-projected private investment and supply responses materialized, although in some respects the adverse consequences of those developments were offset by the unidentified "upside risk" of larger-than-expected foreign investment inflows. The unanticipated portfolio capital inflow "boom" in 1993/94 and 1994/95 created its own special problems of managing economic reform under capital flow volatility."1 Although the SAL should not be faulted for failing to anticipate this particular upside risk, the experiences in other countries (Turkey, Mexico) point to the need for the Bank to give priority to this upside risk. Foreign investment into India, mainly in the form of portfolio flows, rose from an average of about US$300 million per year in 1991/92-1992-93 to over US$4 billion per year in 1993/94-1994/95. This was to create new problems for India's policymakers, such as how to manage the exchange rate, whether to sterilize the inflows, how to control the monetary growth, etc. 25 Relevance: Overview 2.44 The SAL was well founded in good underlying analytical work and well grounded in long-standing relationships and dialogues between Bank staff and Indians within and outside the Government. The SAL/SAP program was strongly owned by the Government, and there was high congruence between the reform strategy advocated by the Bank and adopted by the Government that took over in June 1991. The sequencing of the program was adapted to the Indian political economy, and the Bank was appropriately appreciative of the need for the program to fit the political and institutional realities of the political economy. 2.45 The process of building the dialogue in a low key, low profile manner over time was well managed. Technically, the program was well conceived in dealing first with the most egregious distortions and most binding constraints. The stabilization and adjustment components were on the whole well integrated. Given the constraints to both SAL preparation and aid mobilization prior to June 1991, the Bank responses on these fronts after June 1991 were timely and sufficient. The balance between coping with the short-term balance of payments crisis and in dealing with structural issues was appropriate to the country's circumstances and needs. There was good Bank/IMF collaboration and an effective division of labor and roles between the two institutions. 2.46 The main shortcomings in SAL design and preparation were as follows: (i) the project objectives and conditional ities were (too) numerous and unprioritized; (ii) there were few well- defined and monitorable performance indicators; (iii) provisions to deal with the social dimensions of adjustments were limited, but these issues were specifically addressed through a follow-up operation (the Social Safety Net Sector Adjustment Credit, C2448-IN, approved in FY93); and (iv) the risk assessment was weak and there was no sensitivity analysis or contingency planning, while little attention was given, at least in the project documents, to sustainability. 2.47 On balance, the project was highly relevant. This was, on the whole, the right project at the right time. Its strengths outweigh its shortcomings. The long-term process (of building and managing the policy dialogue) was as important as the product. Both Bank and Borrower performance in the design and preparation of the SAL were fully satisfactory.  27 3. SAL Implementation: Evaluation of Efficacy 3.1 This chapter reviews the SAL's implementation and evaluates the project's efficacy. Efficacy is defined here as the degree to which the project's proximate objectives were met. The project objectives are taken to be the broad objectives outlined in the Letter of Development Policy, not just the covenants applicable to release of the second tranche. 3.2 The PCR provided a good overview of the implementation of the 25 specific conditionalities. With few exceptions, this PAR is in agreement with the PCR findings on implementation. Attention will therefore be focused mainly on the few areas of disagreement, on events in the two years since the PCR was drafted, and on identifying and explaining how and why actual outcomes differed from projected outcomes. Actual vs. Planned Implementation of Policy Reform 3.3 The agenda of reforms laid out in the Letter of Development Policy and the policy matrix to the SAL (Annex I) was an ambitious one, especially in the context of India's history of only incremental reform. That agenda was nearly fully implemented, within the targeted time frames. This was a remarkable and historic achievement, as the Government showed with its actions and not just its plans that it had "seized the day". As Bhagwati put it: "Abandoning the caution and hesitation that defined the earlier efforts at liberalization, the new government has frontally embraced the philosophy of liberal economic reforms. 'Reform by storm' has supplanted the 'reform by stealth' of Mrs. Gandhi's time and the 'reform with reluctance' under Rajiv Gandhi."12 3.4 Compliance with the 25 specific SAL conditional ities was nearly complete by the time of second tranche release in May 1992. The PCR provides a good overview of the implementation of these conditionalities. In several key areas, as the PCR noted, the pace and scope of reforms during the project period (i.e. between approval in December 1991 and closure in December 1991) exceeded the targets set out in the Letter of Development Policy. These included exchange rate policy, liberalization of the import regime, and financial sector reform (although there was some slowdown in the last after project closure). 3.5 There were only three areas of shortfall in compliance with the SAL covenants, viz.: (i) the removal of administrative export controls on selected agricultural products; (ii) the formulation of exit policies for industrial enterprises; and (iii) the initiation of measures to restructure or close unviable public enterprises. Compliance was at least partial, and the Region was justified in proceeding with tranche release notwithstanding these partial shortfalls. These shortfalls, while not critical at the time, did serve as early warning indicators that the implementation of reform might be most problematic in the liberalization of agriculture, exit policy, and public enterprise reform. 3.6 The seriousness of purpose of the new government in implementing the agreed-upon reform program was reflected in its attention to the monitoring of progress. The Government set 12 Bhagwati (1993). 28 up two important committees to facilitate coordination amongst the various line ministries to which the SAL related: a Monitoring Committee, headed by a senior official in the Ministry of Finance, which met every other week; and an Operational Committee, which met every week and reported to the Monitoring Committee. This attention to process was an important determinant of the success of implementation. 3.7 The monitoring and ongoing evaluation of reform progress, both during and after the SAL, was handicapped by the absence of a core set of "intermediate" performance indicators of policy reform, for example rates of protection, indicators of exchange rate dispersion, subsidy levels and the like. The SAL's policy matrix did include some quantitative targets, but given the large number of measures it was often difficult, in the absence of a core set of indicators, for the monitoring teams (both in the Bank and in the Government) to see the forest for the trees.13 The project documents did however include a set of "outcome" targets and projections, described below. 3.8 The most notable improvements in economic management performance included: (i) virtually all licensing restrictions on imports of capital goods and intermediates were removed; (ii) initially a dual exchange rate regime was introduced, with a market-determined rate for most current and capital account transactions and a managed official rate for a few key imports, notably fertilizers and petroleum products; (iii) tariff reductions and other fiscal reforms were incorporated in the 1992/93 budget; (iv) in the financial sector, accounting norms were made more stringent, prudential regulation was strengthened, and interest subsidies were reduced; and (v) there was deregulation of entry and removal of industrial licensing (albeit subject to exceptions). 3.9 These reforms, launched during the SAL period, were followed up by further reforms, particularly in the areas of liberalizing investment, trade policy, tax reform and financial sector reform. The main progress has been in terms of deregulation, trade policy reform, and opening up of the economy. By 1995 India has moved from a regime in which private investment was not allowed in most areas of the economy to one in which the openness to foreign investment compares favorable with most East Asian countries, insurance and railways now being the only sectors reserved for the public sector. In trade policy, maximum tariffs have been reduced from over 400 percent to 50 percent in 1995/96 and the average tariff fell from 87 percent to 27 percent. In the financial sector there have been significant reductions in the statutory liquidity ratio and cash reserve requirements, commercial banks have been given considerably more autonomy, minimum lending rates have been eliminated, and numerous institutional reforms have been launched. Tax reform was slower than envisaged, but a comprehensive tax reform was introduced in 1994/95, and there has been a significant improvement in collections and enforcement. 3.10 In sum, there has been a sea change in the economic regime in the direction of liberalization. But the unfinished a enda of adjustment is a formidable one. The weakest area has been public enterprise reform. For although there has been a virtual elimination of the PEs formerly privileged access to budgetary resources, commercial bank credit and protected markets, and more competition fostered between PEs and private sector enterprises, PE 13 This applied also to the authors of the PCR and the present PAR. 14 This paragraph in large part paraphrases para 14 of the 1995 CAS. 29 managers still lack authority to restructure, retrench, reorganize, sell units, and form joint ventures with private investors. Despite some equity sales, the Government remains the majority shareholder and with few exceptions, PE performance has not improved. Chapter 4 will discuss the matter of PE performance in some detail as a key "sustainability issue." Actual vs. Projected Outcomes 3.11 The following table shows how the actual outcomes of some key macroeconomic variables compare with the outcomes targeted or projected in the project documents, for the three year period 1991/92-1994-95.'1 Table 3.1: Key Macroeconomic Indicators: Actual vs. Projected Values, 1991/92-1993/94 1992-94 Projected Actual Growth Rates (% per annum) GDP 3.8 3.4 Per capita GDP 1.6 2.1 Inflation 9.6 Exports 10.8 11.9 Imports 4.6 9.7 Ratios (% of GDP) Gross domestic investment 22.7 24.6 Private 13.7 15.2 Public 9.0 9.4 Gross domestic savings 21.5. 23.8 Fiscal balance 4.5 6.3 Current account balance -2.1 -0.9 External debt 34.5 36.3 Debt service (% of exports) 26.4 28.3 Values ($ million) Current account balance -5,161 -2,276 Foreign exchange reserves 4,390 Total external debt 86,444 92,278 Foreign investment 489 3,207 Grant aid 604 409 3.12 This table shows that the actual outcomes have been reasonably close to those projected for key macroeconomic variables such as GDP growth, export growth, and savings and investment rates. And although the growth of imports has been substantially greater than was projected, the current account deficit over the period was nevertheless much smaller and the 15 The SAL was approved on December 5, 1991 and became effective on March 4, 1992-less than a month before the end of Fiscal Year 1991/92. The fiscal year runs from April 1-March 31. All calculations concerning annual changes reported in this chapter refer to fiscal years. 30 international reserve accumulation was much larger than anticipated. The latter was due mainly to the large surge of foreign investment-most in the form of portfolio investment-in 1993/94 and 1994/95. The reserve buildup proceeded at a rate of nearly US$1 billion a months over those two years, reaching nearly US$20 billion by end-1994. This created its own new problems for economic management, such as how to avoid a "Dutch disease" effect on the real exchange rate and on monetary expansion and inflation. The composition of the growth has also been encouraging, with industrial growth currently at the rate of about 8 percent annually while agricultural growth also has picked up. The latter has been aided by an unprecedented series of good monsoons. The Government estimates GDP growth to have been 5 percent in 1993/94, 6.3 percent in 1994/95, and 6.2 percent (forecast) in 1995/96. 3.13 Progress on the stabilization front, however, has been lower than targeted. The public deficit averaged about two percent more of GDP than planned, with inflation averaging close to 10 percent annually-as compared with the target of 6.5 percent. Consolidated public sector saving has actually declined, and there is cause for concern especially about state-level public finances. 3.14 It is also significant to note that, whereas the medium-term outcomes in some areas were very close to those targeted or projected, this was not necessarily true of the short-term outcomes. For example, the foreign investment and reserve buildup came quicker than projected, but the industrial recovery and export responses were slower than expected/projected. And as was noted above, the greater-than-expected capital flows created its own problems. In the event, the Government was reasonably successful in avoiding an appreciation of the real effective exchange rate and in accelerating industrial and export growth but not so successful in containing the deficit and inflation. Balance of Payments Outcome 3.15 The SAL policies and funding were unambiguously successful in helping India to overcome its balance of payments crisis. Although the IMF resources provided the bulk of multilateral financing in 1991/92, the SAL's US$500 million (under ordinary conditions, not a very significant sum relative to India's economy and cash flows) was quite significant in 1991/92, partly for its demonstration effect. For the SAL gave greater credibility to the Indian reform program that contributed to the willingness of other donors-notably Japan and the Asian Development Bank-to mobilize hundreds of millions of dollars in additional quick-disbursing resources for India. 3.16 The improvement in India's balance of payments exceeded the most optimistic expectations. Aided by the rapid growth in exports, the current account deficit declined significantly while the increases in foreign investment strengthened the capital account, boosting reserves to an all time high of US$20 billion by early 1995. The combined strengthening of the balance of payments and the economic reforms led to an improvement in India's creditworthiness (commercial risk) ratings as shown in the following table, which also shows ratings for some comparator countries. 16 Table I does not show year-by-year changes and does not therefore differentiate between the SAL period (through CY92) and the post-SAL period. But the data suggests a difference between near-term outcomes and medium-term sustainability. Thus, the budget outcome during the SAL was satisfactory but the sustainability of deficit reduction proved not to be satisfactory. This will be discussed in detail in Chapter 4. 31 1992 1993 1994 1995 India Euromoney rating 44 60 59 Institutional Investor rating 38 42 44 Moody's Ba2 Ba2 Baa3 Baa3 Mexico Euromoney rating 59 62 58 Institutional Investor rating 43 .. 46 47 Moody's Ba2 Ba2 Ba2 Ba2 Turkey Euromoney rating 66 .. 49 55 Institutional Investor rating 44 .. 42 41 Moody's Baa3 Baa3 Ba3 Ba3 China Euromoney rating .. .. 73 66 Institutional Investor rating 55 .. 57 58 Moody's Baal A3 A3 A3 Note: For both the Euromoney and Institutional Investor ratings, the lower the number, the better the rating; I is best. As of March 1996, India's Euromoney rating was 45 (out of 178), its Institutional Investor rating was 48 (out of 133), and its Moody's rating remained at Baa3. 3.17 The table shows that India's creditworthiness has improved in recent years to the threshold of investment grade rating. (Standard and Poor's rating in 1995 and early 1996 of BB+ was just below investment grade, whereas Moody's rating of Baa3 was just above.) India's balance of payments remains vulnerable. As the 1995 CAS noted, about US$24 billion of India's US$95 billion external debt is due to be repaid in the next four years-this being in addition to the rollover of the short-term debt and the rollover of NRI accounts. Added to the financing requirements of the current account deficit (as projected by the South Asia Region), this means that over the next four years India would need to mobilize about US$40 billion of external finance-excluding the rollover of short-term debt and NRI accounts. The experience of Mexico and other countries reveals how vulnerable such countries can be to sudden outflows of portfolio capital. India's large current reserves obviously improve her capability to deal with these vulnerabilities. But India's ability to improve or even maintain its improved credit rating will depend upon the commitment shown by the government emerging from the 1996 elections to stay the course of economic reform. Social Costs of Adjustment 3.18 The PCR does not have a discussion of the social costs of the SAL-supported adjustment program. This is understandable given that (i) the project documents do not provide targets or quantitative framework for assessing the social dimensions of adjustment; and (ii) the continuing paucity of hard data in this area. As the 1995 CAS noted, "in the absence of firm data, definitive 32 answers [about the nature and extent of the social impact of reforms] are not possible.'7 Subsequently, the South Asia Region has prepared an Implementation Completion Report (dated June 22, 1995) on the Social Safety Net Sector Adjustment Credit (Credit 2448-IN of FY93).'8 3.19 In some quarters, there is a perception that the reform process has widened disparities in income distribution and that the adverse effects of the continued high inflation have hurt the poor in particular. The OED mission was able to obtain only partial information, insufficient to confirm or disprove these allegations.'9 3.20 During the first two years of the reforms, cuts in government expenditures led to declines in employment and in real wages. But in the past two years there have been increases in real wages and employment, especially in the rural areas, and social spending has increased considerably in real terms during the four years of the reform program. The Economic Survey points out that Central Plan expenditure on education, health, family welfare, women and children and rural development increased from 0.9 percent of GDP in 1991/92 to 1.2 percent in 1993/94. helping to "protect disadvantaged groups from the adverse effects of the reforms." It also notes that whereas the trend decline in the infant mortality rate paused in 1991 and 1992, it resumed in 1993. And while average agricultural real wages fell during the crisis year of 1991/92, they increased subsequently, thereby "more than neutralizing" the drop in 1991/92. 3.21 The Economic Survey concluded that "these preliminary data are consistent with the view that the economic crisis of 1991/92 adversely affected general living standards in both 1991 and 1991 while the reform-induced recovery led to an improvement in general living standards in 1993" [the last year for which data were available]. This is however a weak assertion, in the absence of information on social expenditures at the state level, trends in the quality of such services, the effects of (high) inflation on the poorest groups, and so forth. Given the importance of getting more robust answers to such questions, it is imperative that the Bank and the Government accelerate their production of the Poverty Assessment and other relevant studies bearing on these issues. A further discussion of poverty and social sector issues follows in Chapter 4. 17 The Regional Office was urged during the 1995 CAS discussions to accelerate preparation of the Poverty Assessment, in order to answer questions (not now answerable) concerning the impact of India's adjustment program on vulnerable groups. OED was unable to obtain advance drafts of the Poverty Assessment that might bear on these questions. 18 The ICR, which rates outcome of the Social Safety Net (SSN) Sector Adjustment Credit as satisfactory, discusses the Central Government's success in increasing spending on the social sectors at a time of fiscal stringency, but does not discuss the role of the state governments where funding appears to have decreased considerably (see para. 4.28 below). The ICR also points out that the SSN "did not make the desired contribution toward the development of a coherent and articulated approach to the medium-term financing of the social sectors, which was one of the aims of establishing the review of financing" (ICR Evaluation Summary, para. 35). A planned OED audit of the SSN is expected to provide further insights into these issues. 19 Much of the information was obtained from Chapter 9 of the 1994/95 Economic Survey prepared by the Ministry of Finance. 20 Inflation in the past four years has been the highest of any four year period over the past 40 years. Given that only some 15 percent of the work force is in the organized sector and that inflation is likely to have more of an adverse impact on the unorganized sectors (where there is no indexing), it is not surprising that inflation is a major political as well as economic issue. The view was expressed that "Indians prefer low growth with low inflation to high growth 33 Efficacy Overview 3.22 The main strengths/successes achieved in implementation were in the swiftness of action taken across a broad front of policy reform (and changes in the rules of the game). These include: (i) the initial stabilization effort (although not intensified over time as planned); (ii) selected tax reforms and the reduction of subsidies; (iii) quick improvement in the balance of payments and the "vote of confidence" in the Indian economy reflected in large inflows of foreign investment; (iv) responsible management of the capital inflows (including limitations on certain types of inflows) so as to avoid appreciation in the real exchange rate and other undesirable effects; (v) trade reforms and deregulation that significantly opened up the economy (including infrastructure) to private sector agents, including foreign investors; (vi) the improved investment climate that ensued from these measures; (vii) the short duration of the downturn in output and employment, followed by rapid industrial growth and good export response after the second year; (viii) continued building of consensus for reform, including at the state level (even in some states, like West Bengal, that were considerably to the left of the Congress and JNP parties); and (ix) the apparent avoidance of significant adverse effects on the poor (although the data do not permit conclusive judgments on this matter). The sequencing of reform, and the integration of its parts-particularly the exchange rate and trade reforms-was exemplary. 3.23 The main weakness in implementation was the inadequate fiscal discipline (mainly on the expenditure side) beyond the initial stage, at both the central and state government levels. This led to high (for India) inflation rate and excessive burden placed on monetary policy, reflected in high real interest rates and some "crowding out" effects. Other weaknesses included (i) slow movement to reform the large and inefficient public enterprise sector and minimal privatization; (ii) lack of reform in labor legislation; and (iii) lack of an action program to change the roles and improve the performance of the public administration, including through capacity building. Most of these areas of concern will be discussed further in Chapter 4. 3.24 In a few other areas, the implementation performance was mixed. In the financial sector, for example, delays in improving the regulatory framework and in implementing associated institutional reforms were reflected in a lack of clarity about the "rules of the game" for certain types of foreign investment, some rigging behaviors in the stock market, and in continued inefficiencies in the banking and insurance sectors. On the other hand, it was a positive development that India consciously avoided the mistakes of other countries that suffered the consequences of pursuing financial sector liberalization too much in advance of improving the regulatory framework. Outcome and Institutional Development Ratings 3.25 Given the high relevance of the objectives (see Chapter 2 above) and the also high achievement of these objectives, the outcome of SAL is rated as satisfactory. 3.26 This PAR rates the SAL's institutional development (ID) impact as substantial, given that ID is understood to refer broadly to "changes in the rules of the game." The Indian reform with high inflation." This is a hypothesis that needs to be tested. And if found to be true, the implications need to be incorporated in both the Government's strategy for pursuing further reforms and the Bank's country assistance strategy, especially the ESW program and the policy dialogue. 21 The PCR did not provide any explicit rating of the project's institutional development (ID) impact. 34 program supported by the SAL clearly represented a major movement away from a paradigm of planning and control to one of liberalization, "market-friendliness" and opening up. In this sense, the changes in the rules of the game, particularly in terms of reducing controls and changing the regulatory framework, could hardly have been more profound. 3.27 The policy matrix shows how broad was the intended ID impact of the adjustment program. The matrix identifies many important ID measures, including the revisions of guidelines (e.g. on industrial licensing) rewriting of legislation (e.g. amending the Sick Industrial Companies Act), abolishing the roles of those occupied with various kinds of government activities (e.g. abolishing the Limited Permissible List for imports), and establishing new regulatory functions and bodies (e.g. bodies to regulate the stock market and the activities of mutual funds). The implementation performance on these ID measures was satisfactory. 3.28 The SAL did not have a capacity building or training components, nor was there any technical assistance project complementary to the SAL. While the existing SAL agenda was quite enough for one operation, a shortcoming of the broader SAP, and of the Bank's country assistance strategy, is that they did not formulate an ID strategy focusing on the capacity building measures needed to ensure effective implementation of the ID changes implied by the reforms. 3.29 Given the pace of reform, India found quickly that its needs ran ahead of its capacities to regulate monopolies, prevent fraud, protect consumers, and to define and enforce new rules in the stock market (where a serious scam emerged in 1992), in bankruptcy courts, and the regulatory framework for direct private investment in infrastructure. Hence, a gap has arisen between the "new rules" and the overstaffed bureaucracy, which needs to be retrained and retooled to perform new functions (and persuaded to stop trying to perform old control functions). In India, as elsewhere, civil service reform and retooling lags behind other forms of reform. Borrower Performance on Implementation 3.30 The Borrower's performance on implementation was good. The slippage on the stabilization side came after the project period. The Borrower took seriously the monitoring of project progress and introduced appropriate processes to ensure that problems in implementation would be promptly identified and rectified. Covenant compliance, as noted above, was satisfactory. Bank Performance in Supervision 3.31 Given the Borrower's seriousness of purpose in implementing this project, the Bank did not have any real difficulties in supervising the project. The quality of the report of the mission that determined the Borrower's eligibility for second tranche release was good. Documentation problems caused some delays in disbursements, but these were not serious. 35 4. The Unfinished Agenda and Sustainability Issues 4.1 This chapter discusses the unfinished agenda of adjustment and some sustainability issues. These include the centrality of stabilization, the trends in public savings and total investment, the implications of the heavy debt burden, the political economy of fiscal adjustment, the lack of reform in the public enterprise sector, the infrastructure constraints, social sector and poverty issues, and the importance of improving the quality of public services. Attention is given in this discussion not only to relevant technical issues but also to political economy and "process" issues. A set of core "sustainability indicators" is identified and proposed as a means of focusing attention, strategy formulation and monitoring efforts on those areas most crucial to sustainability. Stabilization and Public Savings 4.2 In commenting upon a draft of this report, Bank management noted that "regarding the central role of fiscal adjustment in the sustainability of India's reform process, we share [the] views and concerns [expressed in this report]." The Bank's comments went on to say that the importance of substantial and sustained reductions in the Government's fiscal deficit to around 3-4 percent of GDP is keenly recognized by the authorities, and would remain a priority area in the Bank's dialogue with them. This priority was reflected in the last Country Assistance Strategy paper. In this same context, the Bank's comments on the draft PAR found encouraging the considerable reform and modernization of India's tax system undertaken in the last two years, including a reduction of corporate tax rates, simplification of the central excise tax system, a reduction in the number of rates and exemptions, and broadening of the tax base. It was envisaged that these developments would have enduring impacts in the future. 4.3 From the point of view of a viable growth strategy, the indicator that comes closest to capturing the dynamism in the fiscal picture is public savings (of the consolidated public sector). India's public savings performance has been deteriorating since the early eighties and has now plummeted to its lowest point (practically zero). Whereas India's high performing neighbors and competitors in East Asia recorded public savings typically upwards of 5 percent of GDP, India's public savings have declined from 4.1 percent of GDP in 1980-83 to 0.2 percent of GDP in 1993- 94. Moreover, India's gross domestic savings and gross domestic investment ratios in 1993 (24 percent of GDP) were well below those of the East Asian and Pacific Region countries, for which the savings ratio was 35 percent and the investment ratio was 36 percent of GDP.22 4.4 Pre-reform governments focused too much on the capital formation rate and not enough on the determinants of the productivity of investment, and the change in focus since 1991 has been a welcome development. There is a danger, however, that the pendulum may be swinging too far towards downplaying the importance to growth of an increase in public savings as the stabilization strategy faces the difficult problems posed by special interests with large claims on public resources. The 1991-92 budget, during a liquidity crisis, made a forceful effort to come to 22 Source: 1995 WDR. The Government's comments on the draft PAR (see Annex 11) point out that gross dissaving by the Central Government rose sharply in 1993/94, declined in 1994/95, and was estimated (as of February 1996) to decline to 1.7 percent of GDP in 1995/96 (budget estimates). The Government also pointed out that India's gross domestic savings rate of 24.4 percent of GDP in 1994/95 was a record. 36 grips with policy distortions that had over time led to fiscal imbalances of a large magnitude. Subsequent budgets have not succeeded however in carrying forward the savings and stabilization agenda of the 1991/92 budget that constituted a watershed in India's economic policy evolution. The Revenue Deficit and Public Debt 4.5 India's underlying fiscal problem can also be viewed from the perspective of the public debt. The public debt profile over the last two decades reveals two distinct phases: In the 1970s, the debt/GDP ratio showed a modestly declining trend. Beginning in 1980/81, the ratio showed a continuously rising trend, climbing from roughly 30 percent to 71 percent (1992/93). Over this period, the domestic debt of the Central Government increased from 23 to 54 percent of GDP, and the ratio has more or less stabilized since 1992/93. The external debt component of central government, which was about 12 percent of GDP in 1991/92 rose to 18 percent of GDP in 1991/92, but then declined to 15 percent in 1994/95. Overall external debt has risen by 2.1 percent of GDP over the period of fiscal adjustment. 4.6 These trends in the public debt reflect the increase in interest payments by the Central Government which claimed a growing share of government tax revenues-from 50 percent in 1990/91 to 70 percent in 1995/96. As a result, the Central Government faces very strict limits to its freedom of action in regard to expenditures, and finds it increasingly difficult to reduce the deficit. The "revenue deficit" (current deficit of the Central Government) rose from 1.5 percent of GDP in 1980/81 to 2.6 percent in 1989/90 and 3.5 percent in 1990/91. As pointed out earlier, the budget of 1991/92, with its legacy in 1992/93, brought down the revenue deficit by nearly a full percentage point to 2.6, before it rose again to the neighborhood of 4 percent in 1993/94. The Government indicates (Annex II) that the revenue deficit fell to 3.1 percent in 1995/96 and was projected in the 1995/96 budget to fall further to 2.7 percent. 4.7 Fiscal adjustment can take many forms depending on the objectives pursued. When the (short-term) objective is to mobilize adequate resources to fully service debt, it is not so important how the primary deficit is reduced. Fiscal correction, in line with experience in other countries, often takes place through cuts in public sector capital expenditure and in expenditures on badly needed social services. This has an adverse impact on the potential for growth, but the short-run creditworthiness can be maintained. 4.8 But a more desirable objective is to service the debt out of the proceeds of a growing economy. For this purpose, fiscal correction will have to occur predominantly through reduction of current expenditures, thus reducing the revenue deficit (and eventually generating a surplus) in order to maintain the level of investment and subsequently increase it to put the economy on a higher growth path. In India, GDP growth rates between 5 and 6 percent are required just to stabilize the existing debt-GDP ratio, which already involves very high interest payments. This emphasizes the need to reduce the revenue deficit or, in other words, of reducing the saving- investment gap at rising levels of investment. India's recently inadequate progress in this direction threatens the gains made in terms of macroeconomic stability and revival of the growth process. 4.9 But the priority to be accorded to reducing the revenue deficit, as well as the choice of areas and sequence of actions to achieve the objectives, can only come out of the political processes of India's open, plural society. In the Indian context, it would seem that these 37 desirable policy changes can and will come about only gradually. The key question is whether the political process is being steered in the right direction and whether what the Economic Survey (1994/95) characterizes as the "costs of fiscal populism" will be sufficiently contained. With elections coming in 1996, the pressures and costs of such populism are particularly intense just now. Insufficient Public Enterprise Reform 4.10 The lack of progress in the reform of public enterprises is a major constraint on fiscal correction. The magnitude of the problem can be gauged from the following: In 1993/94, out of 240 operating central public sector enterprises, 120 earned profits as compared to 131 during 1992/93. Profits of such profit-making enterprises increased from Rs. 74 billion in 1992/93 to roughly Rs. 97 billion in 1993/94. However, the losses of the non-profit making enterprises also increased from Rs. 41 billion to Rs. 52 billion over the same period. The overall rate of return on capital employed thus increased only marginally from 2.3 percent to 2.8 percent during this period. In fact, the profitability of PEs, in terms of ratios of gross margins and gross profits to capital employed, has not registered any improvement over the period 1981/82 to 1992/93. There has been, if anything, a small decline. As a percentage of capital employed, the rate of return in 199 1/92 was only 2 percent and the dividend paid out was an insignificant 0.6 percent of paid-up capital of Rs. 1 185 billion. These averages, however, conceal wide divergences in performance between the petroleum sector and the rest of the PEs. If the petroleum sector is excluded, the results are even worse and the ratio of profit after tax to net worth is generally negative. 4.11 These indicators tell the story of sizable resource losses suffered by the central budget on a continuous basis for relatively long periods of time as a direct consequence of poor utilization of investment by the public sector. Of the enterprises in the State sector, the State Electricity Boards (SEBs) are by far the most conspicuous loss makers. The commercial losses of the SEBs in absolute terms increased from about Rs. 41 billion in 1991/92 to about Rs. 63 billion in 1994/95 and are projected to increase further to about Rs. 71 billion in 1995-96. These losses are equivalent to about 0.7 percent of GDP. 4.12 It is important to recall here what the Government stated about its intentions to pursue public enterprise reform in the SAL Letter of Development Policy. After stating that the central public sector enterprises as a whole imposed a burden on the exchequer, it was recognized that "actions taken in the area of public enterprise reform will be central to the near term growth performance of the economy, as well as to its medium term transformation." As a first step towards improving the efficiency of central public enterprises, 56 units incurring cash losses for a number of years were referred to the Board for Industrial and Finance Reconstruction (BIFR) for restructuring or winding up. However, in terms of specific action taken either to restructure unviable units or close them down, available information does not suggest any significant movement. 4.13 The Government has spoken in different voices since the policy was first formulated, and some statements of high government officials even rule out closures irrespective of the financial situation of sick units. In any event, the action program promised in the medium-term reform program articulated in the SAL Letter of Development Policy in regard to the restructuring and closure of unviable units has not materialized. Nor has the schedule of qualitative targets for eliminating all budgetary transfers and loans to central public sector 38 enterprises. Only two items specifically outlined in the government program-namely the strengthening of the existing system of Memoranda of Understanding (MOU) and partial divestment of equity in public sector enterprises-have been pursued with varying degrees of success. But in the absence of an overall plan of public sector reform, their efficacy has been limited. 4.14 The crucial dilemmas of policymaking in public enterprise reform may be summed up in three propositions. First, the Government does not have adequate resources either to support loss-making enterprises or to step up the level of investment to modernize and to expand existing profit making enterprises. Secondly, the Government appears not to favor either the closure of unviable and loss making enterprises or their privatization. And thirdly, even in regard to profit- making enterprises, the Government's reforms seem to be limited to Memoranda of Understandings (MOUs, a form of performance contract) and partial divestment, neither of which has done much to bring about improvements in their efficiency to face domestic and international competition. MOUs were a carryover from the past and had no intrinsic element of managerial autonomy, given the fact that basic government policies and procedures concerning personnel matters and investment approvals had not undergone any change. Furthermore, divestment of government equity has come to be seen essentially as a financing device to help the budget. It has few implications for investment or upgrading technology or strategic planning for the future. Labor Market Issues 4.15 There is an important link between public enterprise reform and improving the efficiency of the labor market, another area in which reforms have been few. Movement towards a flexible labor market is hampered by lack of clarity on the public role of the public enterprises. Existing labor legislation has tended to increase capital intensity in the organized sector of industry and has operated against labor intensive production processes. However, in large segments of small- scale industry and in the large informal sector, flexibility exists. Moreover, private sector industry has often been successful in finding ways and means of rationalizing the labor force through direct negotiations with the unions. 4.16 It is mainly in the public sector, therefore, that the deleterious consequences of a labor policy aimed solely at protecting existing level of employment, irrespective of its effects on profitability and production mix, are to be found. In an important sense, policies and practices in industrial relations established by the public sector are the model to which other sectors are compelled to conform. Some areas of freedom remain for privately owned enterprises, but the force of the public sector example tends to be too great to be resisted. 4.17 The employment effects of the post-1991 economic reforms have not yet been studied in depth. The Economic Survey for 1994/95 gives a global figure of increase in new employment creation from 3 million in the crisis year of 1991/92 to 6 million per annum in 1992/93 and 1993/94. The beneficial effect of the revival of the growth process, which accelerated in 1994/95, on employment creation is undoubtedly reflected in these figures mentioned. Nevertheless, even these encouraging results are well below the additional employment target of 8.5 million per year in the Eighth Plan. When the contribution of agriculture, which has remained generally buoyant in the last three years, is taken into account, it may turn out that industrial employment has expanded well below the potential implied by policy changes which have deregulated investment and encouraged competition. 39 4.18 More flexible labor markets would lead to larger employment opportunities, particularly in labor-intensive industries where India has a comparative advantage and where India's share in exports is significantly lower than that enjoyed by China and other developing countries. The key to a more flexible organization of the labor market is held by the public sector whose reform is indispensable, not only from the point of view of budgetary considerations, but from that of overall restructuring of Indian industry as well. Infrastructure: A Key Constraint to Future Growth 4.19 If the sustainability of fiscal adjustment is open to doubt in view of the trends described above, the sustainability of the growth process is no less so. The growth process is beset with a number of problems, in addition to the concern with macroeconomic stability. A foremost constraint to growth is posed by growing shortages of infrastructure. 4.20 Many indicators point to the seriousness of underlying problems. One is the staggering commercial losses in many utilities. But even where profits are being made, as in telecommunications, efficiency is low and the rate of progress to expand the network and to bring it up to international standards is slow. It is now widely acknowledged that the Eighth Plan targets in key infrastructure areas will not be met, in many cases by wide margins. In all areas that contribute directly to growth-power, telecommunications, transport, irrigation, urban facilities, and rural infrastructure-capacity creation will be well below targets that were scaled down on account of shortages of investible resources. 4.21 The Government response to the infrastructure crisis has two tracks. The first is the encouragement of private investment in fields previously earmarked for the public sector. One of the most significant pro-growth features of the reform period is putting in place a policy framework for a systematic induction of large volumes of private capital, both domestic and foreign, into the infrastructure field. The private sector has responded enthusiastically, showing both the presence of significant opportunities and the high probability of adequate returns on capital. But the opening up of India to direct foreign investment in infrastructure is still politically problematic, and the "rules of the game" still need clarification. 4.22 Two aspects of the emerging situation need close attention. First, given the very large requirements of capacity creation, the public sector will continue to perform the leading role in this area. The need for increasing public saving to strengthen the role of public sector as investor in this critical area can hardly be over-emphasized. Secondly, institutional aspects to facilitate quicker decision-making, and speedy and efficient implementation of private investment decisions need more attention. There have been delays in setting up independent regulatory authorities, establishment of transparent criteria for evaluating investment proposals, creation of effective dispute settlement mechanisms, modifications and adaptations of existing laws and regulations to accommodate private actors in the field, and improving procedures for clearance of multistage approvals of complex investment proposals. Priority is warranted to solve these institutional problems. 4.23 The second track in infrastructure development is to improve the operational and organizational efficiency of public sector infrastructure entities and other similar entities at both central and state levels. The challenge is to remake the State Electricity Boards and similar entities into organizations that are financially viable, managerially efficient, and technologically able to hold their own in a competitive environment. Many innovative proposals have been put 40 forward as the policymakers have come to appreciate that the infrastructure crisis is not simply a consequence of inadequate investment, but also the result of colossal organizational failure. Accordingly, pressures compatible with a democratic polity are being exerted on state functionaries at all levels to put their house in order. Competition for private investment is helping to concentrate the minds of decision makers on what has to be done to offer an attractive environment. Social Sector and Poverty Issues 4.24 The distributional issues, always important in the Indian context because of widespread poverty, have acquired a new focus vis-5-vis structural adjustment policies. As noted in Chapter 3, the Bank supported, two years after the SAL, the establishment of a Social Safety Net (SSN) program through its SSN Sector Adjustment Credit. However, critics of the reform program have suggested that reform policies have adversely affected the poor in a variety of ways. Macro-policies are alleged to have led to a reduction of expenditures on social services and on poverty alleviation programs, and micropolicies of liberalization and restructuring are alleged to have resulted in a shrinkage of employment opportunities. The Government has refuted these criticisms, claiming that its policy of "adjustment with a human face" has indeed worked well. As was emphasized in Chapter 3, however, the data available to the OED mission in this area were inadequate to permit much analysis of the social dimensions of adjustment. A recently produced ICR for the SSN Sector Adjustment Credit provides some additional information and OED will conduct an audit of the SSN Sector Adjustment Credit during 1996. Therefore, the following paragraphs are limited to the discussion of some macroeconomic and fiscal data, which, nonetheless, raise some important questions regarding differing trends in public sector expenditure in the social sector between the central and the state governments. 4.25 Available evidence suggests that the revival of the growth process in 1993/94 and its acceleration in 1994/95 should have strengthened the trends of poverty reduction already visible in the eighties. There is no evidence to suggest that the reform process has either contributed to any significant loss of employment opportunities or to declines in income of the poorer groups (such as agricultural labor). Average agricultural real wages did show a decline in the crisis year of 1991/92, but that was not policy induced. It came as part of a generally bad agricultural year. Subsequent increases in wages, which neutralized the earlier decline were accompanied by significant improvements in agricultural productivity which did not owe much to any policy package of the reform program. Inflation, particularly of food prices, which undoubtedly hurts the poor, may have been responsible for adverse perceptions. But the phenomenon of rising food prices has a complex causation including a state-administered procurement crisis which tend to boost rural incomes. 4.26 India's policy on human resource development, with all its implications for both growth sustainability and poverty reduction, has continued to adhere closely to the pattern of the earlier strategy which failed to bring about rapid improvement in indicators of literacy, primary education and health care. The problem is not only a question of spending; it is also a question of achievements from a given spending. Table 4.1 shows how far India has to go to bring many of its basic social indicators up to the level of the faster-growing Asian countries. 4.27 Developments during the reform period in the broad area of poverty alleviation-rural development and social services-present an interesting pattern. In the central budget, allocations were increased significantly from Rs 80 billion in 1990/91 to Rs 179 billion in 1995/96. Table 4.1: Comparative Social Indicators Indicator India East China Pakistan Indonesia Thailand Asia/Pacific (W) Adult illiteracy rate (%) 52 24 27 65 23 7 Life expectancy 61 68 69 62 63 69 Total fertility rate 3.7 2.3 1.9 .. .. 2.1 Population with access to safe water, 1991 75 .. 71 50 42 72 Prevalence of malnutrition (under 5, 1993) 63 .. 25 40 46 13 Expenditure on education (% of total exp.) 2.2 .. 2.2 1.1 10.0 21.1 Expenditure on health (% of total exp.) 1.9 .. 0.4 0.4 2.7 8.2 Weighted averages for these indicators are not available. 42 As a proportion of the Central Government's aggregate budgetary expenditures, the increase was from 7.7 to 10.4 percent, although as a share of GDP, the increase has been marginal-from 1.5 percent in 1990/91 to 1.7 percent in 1995/96. 4.28 When the focus shifts to the states, a different picture is revealed. Their outlays on rural development and social services, as a proportion of their aggregate expenditures, have declined marginally from 38.7 percent to 38.1 percent. Overall, states' spending on these sectors as a proportion of GDP declined a full percentage point from, 6.6 percent in 1990/91 to 5.6 percent in 1994/95. 4.29 Therefore, for the economy as a whole, outlays on rural development and social services as a share of GDP declined by 0.8 percent in the first four years of economic reforms. It is also important to note that the states have reduced their spending on maintenance of existing facilities, which will surely reduce their utility. These trends are inimical to long-term prospects of sustainability. 4.30 These figures highlight the distance that has to be covered in reforming the states' budgets, which are the primary sources for financing programs in the vital areas of education and health. The fiscal deficits of the state governments have continued to remain at high levels during the reform period. There has, of course, been some diminution in net transfer of resources from the Center to the states. But this has not led to better housekeeping at the level of states. Their gross fiscal deficit declined in 1991/92, but has increased again and is now in the neighborhood of 3.5 percent of GDP, similar to the crisis year of 1990/91. The pattern of state budgets reveals a decline in capital and development expenditures as a growing proportion of resources are preempted for interest payments and current expenditures. 4.31 The message is loud and clear. Unless the states carry out a comprehensive reform of their budget, the crisis affecting the social sector will inevitably deepen, thereby clouding the prospects of medium term growth and exacerbating social tensions. This message was one of the principal ones conveyed to the Board in the 1995 CAS. 4.32 As important as the quantity is the quality of services and public goods provided to the society by different levels of government. These cover a wide range of economic and social services including the administration of justice and law and order. Although it is hard to quantify, many observers have remarked a deterioration in standards of public services, giving rise to dissatisfaction among the people. In any event, given the importance of both the quantity and quality of education, health and other public services to the sustainability of the growth-cum- poverty alleviation process, it would warrant high priority for both the Bank and Government to get a firm handle on these issues. A Core Set of "Sustainability Indicators" 4.33 The above discussion has highlighted the importance to sustainability of a number of indicators, namely public savings (at the central and the state level) and investments, the revenue deficits and debt burden, public enterprise profits and productivity, labor market efficiency, and human capital development, among others. 43 Box 4.1: Selected Sustainability Indicators Fiscal Indicators (% of GDP): Government savings - central, state, total Debt service/tax revenues - central, state, total Investment (% of GDP): Public Private Public Enterprise Reform PE profits/losses Rates of return to capital Other efficiency indicators Labor Market Indicators Productivity Public sector employment Human Capital Development 4.34 Indicators of developments and performance in these areas are of course already monitored and analyzed in a variety of contexts. There may nonetheless be some utility in grouping these particular indicators together as a set of "selected sustainability indicators" in the overall assessment of progress in India's reform program, and particularly in the CAS. These are truly "big picture" indicators, and giving them prominence may serve, inter alia, to focus attentions on matters that are truly important, not just merely urgent. Sustainability Rating 4.35 It is not clear at present how the large unfinished agenda will evolve. Political and social forces are simultaneously pulling in many directions. Growth is continuing at a good pace, yet some serious social and economic problems are growing in volume and intensity while the fiscal problems progressively narrow the range of options available to policymakers. 4.36 On the one hand, India's political process showed in 1991 its capacity to come to grips with the defining issues of the economy, and the resilience and creativity of this system must not be underestimated. The policy movement since 1991 has shown the way forward, and there are many reasons to be optimistic about India's economic prospects. There seems little likelihood of an outright reversal of the reforms. On the other hand, sustainability will depend on the pace and intensity with which at which the unfinished agenda is addressed, and this is now uncertain. Hence the rating of "uncertain" for sustainability. 4.37 The Government's main substantive comment (see Annex II), upon a draft of this report, was to reaffirm its commitment to continuing with the reform process, and it expressed "reservations" about the sustainability rating of "uncertain." It is certainly very encouraging that the Government considers the reform process to be "irreversible," but OED still finds it appropriate to rate sustainability as uncertain at this time.  45 5. Main Findings and Lessons Main Findings 5.1 Among the main findings of this PAR have been: (i) that the SAL was on the whole the right project at the right time; (ii) that project preparation was a long-term process that spanned many years of application of all the Bank's instruments; (iii) that the role played by the Bank in helping India prepare the SAL-supported reform program appropriately took into account national sensitivities about that role, and was therefore much more effective that would otherwise have been the case; and (iv) that whereas a strength of the initial reform program as it was designed in 1991 was the strong integration of the stabilization and structural reform components, the current fiscal deficits-both in the Central Government and in the states-pose a major threat to sustainability. 5.2 The SAL was the "right project" because it had appropriate objectives-objectives that were influenced constructively by the Bank through its ESW and policy dialogue over many preceding years. The Bank was able to influence these objectives not only because of the quality of its substantive work but also because of the "quality of the process" through which it pursued the dialogue across a broad spectrum of technocrats, the economic press, the business community and other stakeholders. The "audience" for Bank information and analysis was diverse. Moreover, the objectives of the reform program in general and of the SAL in particular were strongly owned by the Government. 5.3 The SAL took place at the right time because it was a timely response to a window of opportunity created by the 1991 crisis and the change in leadership that brought to power an economic team prepared to "seize the day" and to replace reform by stealth with reform by storm. It was also important that the Bank was prepared to seize the day after so many years of working to be ready for this opportunity. 5.4 The 1991 SAL had appropriately ambitious objectives. At the same time, these objectives were grounded in the political and social realties of the time and place. The objectives were fitted to the process of building commitment and consensus sufficient to ensure their implementation, and vice versa. Nevertheless, the SAL still had too many unprioritized components and lacked a set of core performance indicators. Main Lessons 5.5 The main substantive lesson from the review of the SAL experience is: 46 * the reaffirmation of the centrality of macroeconomic stabilization to the prospects for sustainability 5.6 The findings of this PAR translate into a number of "process" lessons. These lessons are that the effectiveness and quality of Bank assistance in structural adjustment depend on: * the Bank's willingness and ability to move swiftly and opportunistically to respond to crises-which crises may offer a windows of opportunity to take bolder steps than would otherwise be possible; * the mutual understanding between the Bank and the Government about the nature of the problems to be solved-understandings which often require a long period of dialogue and ESW studies that provided a sound diagnostic; * mutual respect and credibility between the people directly involved on the Bank and country sides; * the credibility of the Bank vis-J-vis other donors and creditors-which can be earned through leadership of the aid consortium, discussion of ESW studies, etc.; * good understandings by Bank staff and management of the country's capabilities-and of limitations in those capabilities (technical, institutional and political) to implement various types of reforms within specific time horizons; * good working relations with the IMF that reflect the needs for well-defined divisions of responsibility and also joint focus on issues such as trade and fiscal reforms; * a sensitivity by Bank staff and management to factors that make countries sensitive both to the reality and appearances of roles played by the Bank; * adequate dissemination of Bank studies and discussion of policy issues, tailored to the country's governance conditions; and * the extent to which key sustainability issues are addressed up front, in the design stage. The Centrality of Stabilization 5.7 The main lesson identified by the PCR was that "the Government's success in reducing fiscal deficits was instrumental in enabling it to launch important measures in the key areas of trade, finance and public enterprises. Without such success on the fiscal front, it would have been difficult if not unfeasible to lower custom tariff rates, to reduce reserve requirements on commercial banks, to deregulate interest rates, and to impose a hard budget constraint on public enterprises. [The key role of fiscal adjustment] in enhancing the credibility of the overall reform program and in restoring external confidence cannot be doubted." 5.8 These points are well taken. But by the same token, the subsequent faltering in fiscal adjustment must be seen as an extremely serious threat to India's ability to deepen and intensify the structural reforms and in consequence to accelerate growth and poverty alleviation. 47 Fortunately, this is well perceived by the Government and by Bank staff, so this issue is at the center of the dialogue. The dialogue could be further strengthened by an economic study that further elucidated both (i) the technical causes and consequences of inflation in India, and because inflation is such an important political issue, (ii) the "political economy of inflation" in India. 5.9 A principal recommendation of this PAR is that the Government and the South Asia Region give consideration to adopting a core set of "sustainability indicators" as a means of focusing attention, strategy formulation and monitoring efforts on those indicators that are most crucial to sustainability. A prototype set of such indicators was set forth in Box 4.1 in Chapter 4. The Importance of Country Conditions 5.10 A main theme of this PAR as been the importance to "relevance" of fitting process to place. But because the places (countries, or even states within diverse countries such as India) differ so much in their economic and governance conditions and their experiences with and attitudes towards the Bank, a corollary is that the Bank should beware of generic recommendations. The Indian SAL also showed the importance of mutual understandings and credibility as between the Government and Bank. These are not abstractions between institutions, but realities between individuals. Hence the importance of building into the Bank's country assistance strategies ways and means of building these equivalents of corporate goodwill. 5.11 In many Bank countries, including India, there remains a long unfinished agenda of adjustment. Therefore, in many countries, the Bank will continue to deal with adjustment policies for many years to come. A central lesson of the India SAL is that the Bank should take a long-term view and to develop, country by country, a long-term plan for acquiring the in-depth country knowledge and mutual understandings, at individual as well as institutional levels, that proved so important to the Bank's effectiveness in helping the Indian reform program.  Annex I Page 1 of 9 I IA: STIMICIAL AWJSTMT LOAM/CMIT POLICY PATIN A. MEASLMES ALREADY TAKEN 1. ACTIONS TO BE TAKEN PRIOR AEAS OF REUMN TO SECOND TRANCHE RELEASE IUTRIAL POLICY eam ef Iaitriml regulatry frammrk regarding firmse mry, espewien, fInancing o diVrsifIcatian A&J The Government has abolished industrial licensing for all new, 0 Guidelines teit be issued expansion. and diversification clarifying that industrial projects of all sizes except In 18 lfcwuing decisions on grouei of designated industries and except location (A.1) will be based for projects/fscilities Located solely on envirormental, safety, less then 25 km from cities of lend use, congesti on, urban over one million population. planning, and related concerns. & Amadments to the MRTP Act have been mde via Presidential U The 25% and Re. 20 million Ordinance, abolishing all pre- Limits an autatic &Mpovat for entry clearance requirements for capital goods Imports will be large or dominant firm; the MRTP raised to -50Z and is. 100 million, Act has been reoriented to respectively. emphasize policing. of anopo lIatic, restrictive, and afafr trading practices. AJ The requirement for producers to enter into Phased Manufacturing Program (involving indigenization of the production of parts and components over time) has been eliminated in the case of new projects. AA The mandatory convertibility clause in term loans of financial institutions (under which they had the right to convert a portion of loan value into equity) has been abolished for new projects. & Price and distribution controls on low-analysis fertilizers have been removed. PrntmM of forefen direct L The Government has introduced autometic approval for projects with foreign equity investment up to 51 in high-priority Iadustries, provided that the foreign exchange needed for imported capital goods is covered by the foreign equity infusion and that repatriation of dfvidends is offset by export earnings. 50 Annex I Page 2 of 9 AREAS OF REFORM A. MEASURES ALREADY TAKEN 6. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCHE RELEAS JJ The Goverment has amomced that foreign technical cottaborations would be freely permitted in high-priority industries up to certain Limits on royalty paymnts, and in other industries if no free foreign exchange is required. Ll The Goverment witt adopt a Derewlation of SteeL Inastry satisfactory action plan to deregulate and decontrol the steel industry, including, fnter aife, removal of price and distribution control. Reform of Exit Policy A Recognizing the need to j Amendnnts to the Sick overcome Legislative, regulatory, Industrial Campanies Act of 1985 and other obstacles to adjustment (SICA) to institute more by industrial firus appropriate criteria for sickness, (rehabilitation, restructuring, strengthen the Board for and winding up where necessary), Industrial and Financial the Government has established an Reconstruction (5IFA), improve its inter-ministerial Uorking Group to functioning, and streamlin and review the existing provisions of facilitate procedures wider SIFR the various laws governing tabor ill be prepared and submitted to relations, state and local Partimnt. govermennts' role in industrial restructuring, regulations LI The objectives, scope, governing transfer of land, structure, operations, sources and procedures for Liquidation under methods of funding, criteria and the Companies Act, and other mechanism for providing support relevant aspects. to workers, nature and amounts of such support, and other details of &I Establishment of a National the National Renewal Fud will be Renewal Fund to provide workers specified. This is expected by wfth a safety net to protect thee December 31, 1991. from the adverse consequences of restructuring and technological J Based on the review and development has been amnounced by recmdations of the inter- the Government. ministerial Working Group (se A.8), the Government w l formulate a satisfactory policy to facilitate adjustment by indastrial firm and initiate steps to this end, taking into account the need for adequate safeguards for workers, program for re-deploymat and retraining, and appropriate compensation where necessary. 51 Annex I Page3 of9 AREAS OF REFORM A. MEASURES ALREADY TAKEN 1. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCNE RELEASE TRADE POLICY Rmoval of amergenicy Rerw Bank restrictfans on oport Ll R81 restrictions imposed L It Is expected that by initially as part of megrency December 31, 1991, there mill be measures to deal with the further .e an of margin critical batance of payments rapirements for export rotatad situation have been partially imports and capital go relaxed, in particular for financing restrictions affecting export-related Imports. exporters. -s second tranche relese r319ve the following RBe restrictiors margins, qLwjing system for L/Cs, and capital oods financing rairionts fe*tion of d1ocretionarV impoi Licening (Qf) ex tAs part of Its efxforts of moving from rmv to a price-based import regime system, the Government replaced the REP $chom with a new tradeable ooport fntitement eExim scrqpu wi th broadr coverage ad higher retention rate AlI In August 1991 a nmber of Ll Move intordedisto Items on intermediate goods an the the restricted List (Appendix 2B) restricted list (Appen (x 2) corresponding to at least an corresponding to one-third of the additio one-third of the doetic output of such produacts domestic produaction referred to were made freely importable by in A.3 to be freely importable by Eximcrip or on Open General xoascrip or on pa,.. mowever, License t OhL). consmr goods aiLh contin to be restricted mid ilt remain on Appendix n. Certain prodcts Lm e ods i continue to be restricted for health, environmental and security reasons. Reduation in state monpoy on Imot (damaLttation) A1A The replacement of REP fl Implement a satisfactory licenses by the Eximacrip program of reductions and Increased the volume of certain elimination of the official canalized Items also importable foreign exchange allocated to the by private individuals or firms pubIlc sector agencies in using these licenses. A nmber connection with the phasing out of minor Items decenalized (i.e., of dual pricing of previousty for those Items pubic sector decanalized Items. Decanslize import monopoly eliminated) in all remaining canalized products August 1991. Private imports except petroleum products, atLowed under 0OL in some cases fertilizers, oflseeds, cereals, and in others using Eximecrip. certain fatty acids and acid oils, and other acceptable products. In the case of the products for which private Importers must use Eximacrip, either require the canalizing Annex I 52 Page 4 of 9 AREAS OF REFORN A. EASfES ALREADY TAKEN B. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCHE RELEASE agency to al use Eximscrip from the date of decenelization or amo-s-e a satisfactory program of progressive reductions and elimination of official foreign exchange to the p"t ic sector agencies in order to phase out dual pricing. Redution in af an coitat goo& import fM Allow all unlisted capital goods to be imported with Eximscrip whether or not the Eximsrip Is earned by the exports of the importing firm. Remove a sabstantial proportion of capital goods (corresponding to at teast 50 percent of protected danestic production) from the capital goods restricted List (Appendix lA). Production from wdich protection by import Licensing is removed mitt not include capital goods the import of which remains restricted for health, environmental or security reason0. Incresed flefbftfty of imrt regime AI Since April 1990 Imports U1 Abolish the wActual Usern under transferable REP licenses requireamnt for imports. have not been subject to *actual userm conditions. Actual user conditions also do not apply to the such Larger volume of Eximscrip imports. Incrased tramparency in import regim A In October 1991 a 1A Abolish the Limited computerized List corresponding Permissible List (Appendix 3). to Customs Tariff NSC Anmouace that a1 products not on classifications giving import Restricted Lists, the Canalized control status of each product Lists, or the OGL Lists are was Issued. importable with the use of Eximscrip. LZ Abolish the purchase preference given by the Directorate General of Supply and Disposal (DGS&D) and to domestic suppliers over the duty paid price of imports. Annex I Page 5 of 9 AREAS OF REFORM A. MEAsuRES ALREADY TAKEN B. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCHE RELEASE Epert Inwanties and removet of ono-tariff hmriam to supets in August 1991 a new Advance License Scheme was introduced which broadens. simplifies and speeds up export incentives for manufactured goods. &A GOI decanalized same Remove sit t rt licensing, exportable products on August 13, canalization and minfam export 1991 and decontrolled som others prices ewept for a satisfactory on September 4, 1991. Further negative list. decontrol measures were taken in October 1991. GO! is continuing to review export controls and export canalization, in particular existing policies towards agricultural and mineral exports. ariff reform LI The Government has partially Ll Completion of the customs rotted back the earlier tariff tariff review and adoption of a increases adopted in the context satisfactory medium term plan to of fiscal adjustment of December meet the objectives set out in 1990 and the maximum ad valorem A.10. A substantial initial tariff (basic plus auxfiiary) was reduction of the maximum custome lowered to 150 percent. tariff to be introduced In the 1992/9 budget. L. The GOI is undertaking a comprehensive review of the custom tariffs in order to recoend among other things, ways and means for: (M) substantially reducing the average level of tariffs; (ii) significantly lowering the maximum level of tariffs; (iII) simplifying the structure of tariff rates with a view to substantially reducing their variability and the Incidence of exemptions and partial exemptions; (iv) minimizing the use of specific tariffs; Cv) obtaining alternative revenue sources to cmpensate for any reduction in total government revenue which my follow from the tariff reform. 54 AnnesI Pap,e 6 of 9 AREAS OF REFOR14 A. MEASURES ALREADY TAKEN B. ACTIONS TO SE TAKEN PRIOR TO SECOND TRANCHE RELEASE FINANCIAL MARKETS AND INSTITUTIONS interest rat Ufberatization j6 Significant progress has been achieved in introducing greeter flexibility and autonomy in the determination of term lending rates. Minimua Lending rates for both commercial banks and finncial institutions have been increased to 20% and 15% respectively, with both institutions given the freedom to add margins, depending on borrowers' creditworthiness and market conditions. &a Term deposit rates have been increased across the board by 1 to 2 percentage points (deposit rates, however, remain still under the administrative control of the Not). Retion in the acope of directed credIt attacation scheme Al A panel (Narasimbas Committee) has been established L I Ulth the reduction of the with the mandate to review all fiscal deficit of Central relevant aspects of structure, ooverrnmet as a proportion of DP organization, functions and take measures to progressively procedures of the financial reduce the Statutory Liquidity system, and make recommendations Ratio required to be maintained by for reform by mid-November 1991. the scheduled commercial banks, starting from April 1992. LZ Based on the recommendations of the Marasimam Camittee, formulate a satisfactory program of action to redue interest subsidies in areas of directed Capitat sorkst rewLatwry ai credit, beginning in April 1992. Istitutional refm A. Restrictions on interst rates for debentures issued by corporations in capital markets, both convertible and n=m- convertible, have been completely removed (exemption applies however to tax free bonds issued Of *Ae public sector). AI The Coupon rate on Goverromet securities has been raised by one- hallf of a percentage point from 11.5% to 12% (20-year boeM. 55 Annex I Page 7 of 9 AREAS OF REFORW A. MEASURES ALREADY TAKEN B. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCHE RELEASE SAnnouncmint has been made to g1 Prepare and present to grant full statutory powers to the Parliament legislation to give Stock Exchange Board of India MffI statutory status in order to (5EBI) under the Securities operate ma an independent Contracts (Regulation) Act and the regutatory body, including power Company Act. to investigate with due diligence. &Z Announcement has been made to 1,_ Adopt a satisfactory Program introduce a comprehensive peckage of action to reform the trading of reform to improve the trading mechanism of stock exchanges, mechanism of stock exchanges, including a system of national including a system of national clearing and settlement and clearing and settlement and setting up a central depository setting up a central depository trust. trust. Private sector participation in the uual fwd indhstry A The mutual funds industry is Ll Based on the recomendazim being opened for private sector of Dave Comittee, formlate and participation. A high level implement a satisfactory Program Committee (Dave Committee) has of action for setting up of mutual been established to review the funds in the private sector. existing regulatory framework for the mutual fws industry with a view to preparing a draft legislation for regulation of mutual funds and other offshore funds, including such funds which may be a step uip in the joint/ private sector, and to make recommendations on any other matters which is relevant for the orderly growth of mutual funds. 56 Annex I Page 8 of 9 AREAS OF REFCOM A. MEASURES ALREADY TAKEN B. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCHE RELEASE PUBLIC ENTERPRISES REFORM RtiOnalizing the SCPe and the rete of de putic sector A.1 The Government has avouced that the pubt ic sector is to concentrate on essential infrastructure, exploitation of oft and mineral resources, crucial areas where private investment is inadequate, and strategic-related activities. It was announced that the existing portfolio of public enterprises wilt be reviewed, with a view to focusing the public sector on strategic areas, high- tech, and essential infra- structure. The List of industries reserved for the public sector has been reduced from 18 to 8. Reductierr in budgetary suport to *wdtic sector enterprises 6AX Budgetary support to central Ll As pert of its program of pub"ic enterprises has been fiscat adjustment and to ease the reduced significantly, with burden on the budget, the Monptan loans and transfers to Goverrment will adopt end initiate public enterprises projected to the imptementstion of a drop by about 25% in 1991-92 and satisfactory phased action plan to budgetary plan support for etiminate within three years investment by pubtic enterprises (i.e., by the end of 1994/95) (toans and equity contributions) budgetary transfers and loans to by l0x. sick central public enterprises and budgetary plan suport (Loah and ewuity for public enterprise investments except in energy, transport and o hr infrastructure. Under the action P.., Government guarantees of central public enterprise borromings will be Limited to essential infrastructure exploitation of oil and mineral reserves, and strategic-related activities. Formulation of an exit p*Licy far pudtic enterprises AJ The Government is developing LZ In the case of units that are an exit policy for public patently unviable, the Government enterprises. wiLL form a satisfactory action progre to initiate restructuring and closure procedures. 57 Annex I Pae 9 of9 AREAS OF REFORM A. NEASURES ALREADY TAKEN 8. ACTIONS TO BE TAKEN PRIOR TO SECOND TRANCNE RELEASE jJ The Government mill take actions to ensure that, except for cmntrai publie enterprises already determined to be unviable by the Government (5.2). all public enterprises that are sick according to the criteria specified in the Sick Industrial Companies Act (SICA) henceforth witt automatically be referred to the Soard for Industrial and Financial Reconstruction (IFR) for assessment of their prospects and subsequent minding up or rehabilitation. ALl such sick central public enterprises iltt be referred to lIFR. Divestiture A _ Government disinvestment of 5.4 The detailed program for 20% of the equity of selected disinvestment of 205 of equity in public enterprises has been selected public enterprises, to anomced; shares would be sold to yield Rs 25 billion, witt be Mutual funds and other financial finalized and approved by the institutions, which will then Government and inplementation of reset them to the general public. the program mill be completed by Disinvestmnt is expected to yield the end of 1991/92. proceeds of at least is. 25 billion for the budget in 1991-92. tj Building on the 20% disinvestment, a satisfactory action program to progressively increase the private equity share in profitable central public enterprises to 49% within three years witl be promulgated by the Government, along with a List of the canpanies concerned and a timetable for Iplementation.  59 Annex II Bin 8Page 1 of 2 D.0. No.366 PS V. Govindarajan, Joint Secretary(FB) Tel.No.3012752. 07.03.1996 Dear f Please refer to your letter dated 7th February, 1996 forwarding therewith the draft Performance Audit Report (PAR) on the Structural Adjustment Loan/Credit (Loan 3421-IN/Credit 2316 IN). 2. While we agree with most of the conclusions of the Performance Audit Report including those on the Balance of Payments outcome, we have reservations on the rating of "uncertain" for sustainability of the project as mentioned in para 4.36 of the PAR. We have time and again demonstrated the Government's commitment and resolve to continue with its process of opening up the economy and enhancing efficiency through domestic and external competition. The structural reforms have been focussed on fiscal adjustment, deregulation of domestic industry and promotion of foreign direct investment, liberalisation of the trade regime, financial sector reforms as also initiation of public enterprise reform. We may add that the reform process is irreversible and would be continued to achieve a greater degree of integration with the world economy. 3. Our specific comments on the issue of 'Stabilisation and Public Savings' (paras 4.2 to 4.4) and on 'Revenue Deficit and Public Debt" (paras 4.5 to 4.9) are as under: Stabilisation and Public Savings: Of late the situation has changed. Gross dissaving by the Central Government which rose sharply in 1993-94 and then declined in 1994-95 (Revised Estimates), is estimated to decline further to 1.7 per cent of GDP in 1995-96 (Budget Estimates). Revenue Deficit and Public Debt. The latest available estimates indicate that in India: - GDP had grown by 5 per cent in 1993-94, 6.3 per cent in 1994-95 and is estimated to grow by 6.2 per cent in 1995-96. Thus, despite the deep crisis of 1991-92, average growth over the first four years of the Eighth Plan at 5.7% is higher than the Plan target of 5.6 per cent. - Government debt, consisting of internal and external 60 Annex 11 Page 2 of 2 liabilities, fell from 69.7 per cent of GDP in 1993-94 to 67.0 per cent in 1994-95 (Revised Estimates). - Revenue deficit as a per cent of GDP has fallen from 4.1 in 1993-94 to 3.1 in 1995-96 (Revised Estimates) and is estimated to be 2.7 in 1996- 97 (Budget Estimates). - The Gross Domestic Saving rate set a new record of 24.4 per cent in 1994-95, exceeding the recent peak of 23.6 per cent in 1990-91. As regards para 5.11 of the report we consider that it does not serve useful purpose and, therefore, could be deleted. Based on the position explained above, we feel that the relevant portion of the draft Performance Audit Report on the Structural Adjustment Loan/Credit needs to be modified. Yours sincerely, (V. GOVINDARAJAN) Mr. Javad K Shirazi Director Resident Staff in India, World Bank, New Delhi.    OL +12: 4E