Coping with internal and external exogenous shocks : India, 1973-74 to 1983-84

DRAFT FOR STAFF USE ONLY. (COPING WITH INTERNAL AND EXTERNAL EXOGENOUS SHOCKS; INDIA, 1973-74 TO 1933-834 Pradeep K. Mitra Suresh D. Tendulkar (Consultant) CPO Discussion Paper No. 1986-21 April 1986 CPD Discussion Papers report on work in progress and are cirCulated for Bank staff use to stimulate discussion and comment. The views and interpretations are those of the authors.  First Draft Comments Welcome COPING WITH INTERNAL AND EXTERNAL EXOGENOUS SHOCKS: INDIA, 1973-74 to 1983-84 Pradeep K. Mitra - and Suresh D. Tendulkar 2/ April 1986 This paper has been done for World Bank Research Project No. 672-74, Adjustment in Oil Importing Countries. We are much indebted to Hector Sierra for numerically implementing the model used in this paper with extraordinary speed, and to him, Shyamalendu Pal and Derek McGreal for setting up and running the simulations. Thanks are also due to them and to Shanta Devarajan for many useful conversations and to T. N. Srinivasan for discussions on the distributional aspects of the model. We also owe a special debt to Alex Meeraus and Arne Drud for advice on implementing the model in the General Algebraic Modelling System (GAMS), on the use of the algorithm CONOPT, and on computational aspects generally. The usual disclaimer applies. The World Bank does not accept responsibility for the views expressed herein which are those of the authors and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries, or national affiliation. 1/ Senior Economist, Country Policy Department, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. 2/ Professor of Economics, Delhi School of Economics, rJniversity of Delhi, Delhi - 110007, India  Coping with Internal and External Exogenous Shocks: India 1973-74 to 1983-84 by Pradeep K. Mitra -/ and Suresh D. Tendulkar -/ Abstract This paper (1) analyzes and interprets the adjustment of the Indian economy to the twin exogenous shocks of oil price increases and harvest failure during the period 1973-74 to 1983-84; (2) implements a six-sector economywide general equilibrium model to a consistent data set for 1973-74; (3) uses the model to approximate the principal developments in the Indian economy during 1973-74 to 1983-84; and (4) explores the consequences for the macroeconomic aggregates, intersectoral resource allocation and income distribution of different policy packages for adjusting to various kinds of shocks. Counterfactual policy experiments with the model allow the following conclusions to be drawn. First, workers' remittances, borrowing from oil facilities and concessional aid more than offset the adverse impact of terms of trade losses following the two oil shocks, making possible higher consumption and investment and lending to higher external debt. Second, a more 'expansionarv" investment strategy in 1974-75, comparable to that of 1979-80, combined with selective imports of essential consumer goods to maintain domestic per capita availability, would have led to higher GDP and private consumption and increased domestic production of capital goods at the expense of consumer goods. As before, it would also have left the economy with more external debt. Third, a less cautious policy of reserve accumujlation between 1976-77 and 1979-80 would have led to similar effects but with a lower external debt burden because the hiaher investment would have been financed in part by reserve decumulation rather than inflows of foreign capital. Fourth, the cumulative effects of weather-related agricultural peaks dominated those of the troughs over the 1973-74 to 1983-84 period, resulting in greater availability of wage goods and higher savings, investment and terminal capital stock. (Continued) 1/ Senior Economist, Country Policy Department, The World Bank, 1.818 H Street, N.W., Washington, D. C. 20433, U.S.A. 2/ Professor of Economics, Delhi .7chool. of Economics, University of Delhi, Delhi - 110007, India  -2- Finally, the paper begins to explore the question of how investment is best reallocated among sectors in response to exogenous shocks. A seemingly plausible but myopic rule of reallocating investment across sectors in response to differences in short-run profitability would have raised GDP and private consumption, while pulling resources out of nontradeables and towards the tradeable sectors of the economy. However, it would have worsened the current account position and led to a higher external debt burden. A disaggregated treatment of rural and urban households allows attention to be focused on the consequences of different policies Lor the size and functional distribution of income. The impact of the alternative policies described above on the size distribution of income and consumption in rural and urban areas was not significant.  COPING WITH INTERNAL AND ETERNAL EXOGENOUS SHOCKS: INDIA, 1973-74 to 1983-84 Table of Contents Page SUMMARY AND CONCLUSIONS ............................................. i I. SHOCKS AND ADJUSTMENT Background ............................................ i The First Oil Shock ................................... i The Intervening Years ................................ii The Second Oil Shock .................................ii. II. CONCLUSIONS ...............................................iii Chapter 1: OVERVIEW ................................................ I. INTRODUCTION................................................1 II. ADJUSTMENT TO SHOCKS: GENERAL CONSIDERATIONS ..............2 III. INDIAN ECONOMY BEFORE 1973-74: A PERSPECTIVE ..............4 IV. ADJUSTMENT TO THE FIRST OIL SHOCK OF 1973/74 ...............8 V. ADJUSTMENT TO THE SECOND OIL SHOCK: 1979/80 TO 1983/84........................................ 21 VI. OVERALL ASSESSMENT ........................................ 31 Chapter 2: THE MODEL ......................................42 Production ........................................... 42 Income Generation .................................... 45 Final Demands ........................................ 46 Trade ................................................ 46 Market Clearance (Goods) ............................. 47 Factors .............................................. 47 Investment and Savings ............................... 48 Government...........................................48 Dynamics............................................. 49 Debt.................................................. 49  Table of Contents (Continued) Page Chapter 3 THE MODEL A! WORK................................... 50 I. INTRODUCTION .............................................. 50 II. COMPARATIVE STATICS Changing Internal Variables...................... 51 Agricultural Harvest Failure ......................... 51 Consumer Goods Sector ........................ .... 53 Capital Goods and Intermediates............ 53 Infrastructure and Services .,...............e......... 54 Decreasing the Savings Propensity of Households...... 55 A 10 Percent Increase in Real Wages..................56 Changing External Variables .e..@... .o.... 57 A 30 Percent Increase in Export Prices...............57 A 50 Percent Rise in Import Prices ...................58 A 10 Percent Increase in Export Volume ............... 59 A 100 Percent Increase in Foreign Savings ............ 60 III. TRACKING HISTORY........................... ............... 6 Methodology..................................... 62 Input Data ........................................... 63 Discussion of Tracking ............................... 65 Features of the Historical Run ....................... 73 Chapter 4e SIMULATIONS WITH THE MODEL ........... .......... .... 85 I. INTRODUCTION .................. ............ 85 Experiment 1: No External Shock-Cum-Accommodating Borrowing..................... . 86 Experiment 2: Alternative Adjtustment Strategy.......90 Experiment 3: No Agricultural Shocks ................ 93 Experiment 4: Reserve Decumulation Between 1976-77 and 1979-80................... 94 Experiment 5: Investment Reallocation ............... 097 Adjustment and Income Distribution .................. 100  Table of Contents (Continued) Page Chapter 5: CONCLUSIONS ...................................... 116 I. INTRODUCTION ............................... 116 II. RESULTS OF THE POLICY SIMULATIONS ........................... 116 No External Shock-Cum-Accommodating Borrowing..........116 Alternative Adjustment Strategy ........................ 117 No Agricultural Fluctuations ...........................118 Reserve Decumulation ................................... 118 Investment Reallocation ................................ 1l9 Adjustment to Exogenous Shocks and Income Distribution ........................................... 120 III. CONCLUDING REMARKS........................................... 121 Appendix 1: Equations of the Model ..................................124 Notation: ........................................................ 150 Appendix 2: The Debt Module ......................................... 159 Appendix 3: The Bivariate Lognormal Distribution .................... 163 Appendix 4: Data Base ...............................................172  iv - Table of Contents Page List of Tables Chapter 1 Tables Table 1.1 Trend Rate of Growth Per Annum for Selected Periods and Items ................................................ 10 Table 1.2 Surplus (+)/Deficit (-) on Current Account ............... 13 Table 1.3 Terms of Trade Effect .................................... 14 Table 1.4 Export and Import Outlays .................................15 Table 1.5 Indices of Imports and Exports ........................... 16 Table 1.6 Crude Oil: Import-Bill, Net Import-Availability Ratios and Production-Consumption Ratios .................17 Table 1.7 Selected Items on Invisibles in Current Account .......... 18 Table 1.8 Gross Domestic Fixed Capital Formation ................... 24 Table 1.9 Rates of Gross Domestic Capital Formation ................25 Table 1.10 Growth Rates of Index of Industrial Production ........... 26 Table 1.11 Trend Rates of Appreciation (+)/Depreciation (-) of Exchange Rates ........................................ 34 Table 1.12 Trend Rates of Appreciation (+)/Depreciation (-) of Exchange Rates.................................... 35 Table 1.13 Trend Growth Rates of Export-Earnings from Goods at Current Prices ............................................ 36 Table 1.14 Trend Growth Rates in Exports and Imports ................ 37 Table 1.15 Trend Growth Rates in Exports & Imports: Volume and Unit Values ........................................... 38 Table 1.16 Trend Growth Rates of Crude Oil: Domestic Output and Net Imports (in million tonnes) ...................... 39 Table 1.17 Trend Growth Rates in Real GDP & Gross Fixed Capital Formation ........................................ 40 Table 1.18 Trend Rates of Growth of W.holesale Prices ................41  Table of Contents (Continued) PLage List of Tables (Continued) Chapter 3 Tbles Table 3.1 INDIA: Selected Features of the Economy, 1973-74........75 Table 3.2 INDIA: Selected Features of the Economy, 1973-74 Share of Consumption by Sector and Group (Constant prices)............................... 76 Table 3.3 INDIA: Comparative Statics Experiments on "Internal" Variables, 1973-74 (Percentage deviation from base period).. ....................... . ............ 77 Table 3.4 INDIA: Comparative Statics Experiments on "External" Variables, 1973-74 (Percentage deviation from base period) ............................................. 78 Table 3.5 INDIA: Input Data for Tracking. ...................... 79/80 Table 3.6 INDIA: Tracking Indicators............................81 Table 3.7 INDIA: Selected Features of the Historical Run (N4odel-generated) ......................................... 82 Table 3.8 INDIA: Debt Profile: Historical Run (tens of millions of 1973-74 rupees)........................... 83 Table 3.9 INDIA: Total Debt Service: Historical Run (tens of millions of 1973-74 rupees).............. ........84 Chapter 4 Tables Table 4.1 INDIA: No External Shock-Cum-Accommodating Borrowing Experiment: Selected Features (tens of millions of rupees) ..................................................101 Table 4.2 INDIA: No External Shock-Cum-Accommodating Borrowing Experiment: (Percentage deviation from historical run)..102 Table 4.3 INDIA: No External Shock-Cum-Accommodating Borrowing Experiment: Distributional Characteristics (Percentage deviation from historical run) ...........................103  - vi - Table of Contents (Continued) Page List of Tables (Continued) Chapter 4 Tables (Continued) Table 4.4 INDIA: Makeup of Sector 5 from 115 Sector Input- Output Table, 1973-74 ...................... 104 Table 4.5 INDIA: Alternative Adjustment Strategy (Percentage deviation from historical run).......................... 105 Table 4.6 INDIA: Alternative Adjustment Strategy Distributional Characteristics (Percentage deviation from historical run) .................................... 106 Table 4.7 INDIA: No Agricultural Shock Experiment (Percentage deviation from historical run) .............. 107 Table 4.8 INDIA: No Agricultural Shock Experiment Distributional Characteristics (Based on historical run) ......................................... 108 Table 4.9 INDIA: Reserves Experiments (Basic Data) ............... 109 Table 4.10 INDIA: Reserves Experiment (Bold) (Percentage deviation from historical run) .............. 110 Table 4.11 INDIA: Reserves Experiment (Bold) Distributional Characteristics (Percentage deviation from historical run) .................... ................ 111 Table 4.12 INDIA: Reserves Experiment (Conservative) (Percentage deviation from historical run) .............. 112 Table 4.13 INDIA: Reserves Experiment (Conservative) Distributional Characteristics (Percentage deviation from historical run) ........................... 113 Table 4.14 INDIA: Investment Reallocation Experiment (Percentage deviation from historical run).............. 114 Table 4.15 INDIA: Investment Reallocation Experiment Distributional Characteristics (Percentage deviation from historical run) ................... 115  - vii - Table of Contents (Continued) Page Appendix 4 Tables Table 1. Mapping Scheme for Sectoral Aggregatione............177 Table 2. Domestic Input Output Table (tens of millions of rupees) ................................................. 178 Table 3. Derived Aggregated Use-Pattern of CSO-NAS IOTT- Based Sectoral Imports (Rs. lakhs) ................... 179 Table 4. Sector-specific Estimates of Depreciation and of Net and Gross Value Added ....................................... 181 Table 5. Assumptions Made Regarding the Services Sub-sectors for Pre-tax Factor Incomes ............................. .183 Table 6. Factor Income Matrix ..................... 186 Table 7. Per Capita and Aggregate Pre-tax Incomes for Rural and Urban Populations...........e.........................187 Table 8. Derivation of Rural and Urban Factor Incomes ............ 188 Table 9. Distribution of Work-Force by Sectors.................... 90 Table 10. Estimates of Sectoral Capital Stock, Gross Pre-tax Rates of Return and the Ratio of Capital Stock to Value Added............. ............ ............. ........... 92, Table 11. Estimates of Trade and Transport Margins in Final Consumption Expenditure.................................. 194 Table 12. Sector-specific Margins Plus Indirect Taxes as Percentages of Final Consumer Expenditure at Producer Prices ................................................. 195 Table 13. Price Indices used for Converting LES Parameters to 1973-74 Market Prices Matrix (6x9)....................196 Table 14. Transformation Matrix for Mapping L" Commodity Groups into I-0 Sectoral Classification ......................... 197 Table 15. Sector-specific Rates of Indirect Taxes by Types of Taxes .................................................. 200 Table 16. Sector-specific Rates of Indirect Taxes on Domestically Produced and Imported Intermediate Inputs and Final Demand ..................................................201  Table of Contents (Continued) Page List of Charts Chart 1 INDIA: Tracking 1973-74 to 1983-84 GDP at Market Prices (Growth Rates) . ..................... 66 Chart 2 INDIA: Tracking 1973-74 to 1983-84 GDP at Market Prices (1973=1) ............................ 66 Chart 3 INDIA: Tracking 1973-74 to 1983-84 Private Consumption (Growth Rate) ........................ 67 Chart 4 INDIA: Tracking 1973-74 to 1983-84 Private Consumption (1973=1) ........................... 67 Chart 5 INDIA: Tracking 1973-74 to 1983-84 Total Investments (Growth Rate) ........................... 68 Chart 6 INDIA: Tracking 1973-74 to 1983-84 Total Investments (1973=1) .............................. 68 Chart 7 INDIA: Tracking 1973-74 to 1983-84 Exports (Growth Rate) ...................... ............69 Chart 8 INDIA: Tracking 1973-74 to 1983-84 Exports (1973=1) ........................... ............. 69 Chart 9 INDIA: Tracking 1973-74 to 1983-84 Imports (Growth Rates) ................................... 70 Chart 10 INDIA: Tracking 1973-74 to 1983-84 Imports (1973=1)................................70  SUMIMARY AND CONCLUSIONS I. SHOCKS AND ADJUSTMENT Background The two kinds of exogenous shocks to which the Indian economy had been subjected in the 1960s were: (1) harvest failure and (2) abrupt cessation of foreign assistance. Adjustment to the first took the form of foodgrains imports under PL480 and moves towards self-sufficiency via extension of irrigation and adoption of chemical-biological technology. Adjustment to the second was effected through cutting public investment. The First Oil Shock The early seventies witnessed a peak harvest in 1970-71, a severe drought in 1972-73 and a sequence of indifferent harvests which was not to be reversed till 1975-76. A steep rise in defense expenditure during the creation of Bangladesh led to accelerating inflation. The quadrupling of oil prices in 1973-74 against this background was probably perceived as temporary and responding to it deemed less important than arresting inflation. The policy response to these shocks was (1) to reduce private disposable inccme through a series of fiscal and other measures; (2) to import wage goods in years of domestic shortfalls; (3) to encourage export expansion which was made possible by underutilized capacity in manufacturing and real exchange rate depreciation; and (4) to resort to foreign assistance, to a large extent from the IMF. The balance of payments was further helped by a  slowdown in the imports of intermediate and capital goods and a continuous rise in workers' remittances. By these means, a record current account deficit in 1974-75 was converted into a surplus in 1975- 76 and remained so before turning into a small deficit on the eve of the second oil shock of 1979-80. However, wnen view-ed in the historical perspective of 1950-51 to 1965-66, there was a deceleration in the rate of growth of investment and virtually no change in the rate of growth of GDP. In summary, it appears as if the balance-of-payments adjustment and curtailment of inflationary pressures were achieved at the expense of growth in investment. The Intervening Years Two bumper harvests in 1977-78 and 1978-79 and the. unanticipated growth of private remittances led to the accumulation of food and foreign exchange reserves. However, the experience with inflation in 1972-73 and 1974-75 and some uncertainty regarding how long reserves would continue to accumulate inhibited policy makers from stepping up industrial investment and imports of capital goods. The Second Oil Shock The combination of a more than doubling of oil prices and a severe drought in 1979-80 potentially fuelled inflationary pressures as well as adding very substantially to the POL (petroleum, oil and lubricants) import bill. However, the background against which this occurred was very different from that of the first oIl shock, since India had comfortable reserves of food and foreign exchange. It was partly because cf this, as well as a growing realization that the oil - ii -  price increase was a relatively secular phenomenon, that the policy response was different. Adjustment comprised (1) import liberalization to promote doxnestic efficiency via international competition; (2) domestic oil exploration; (3) measures to switch eneray use away from POL and towards domestically available coal and electricity; (4) increased public investment and a concomitant rise in imports of capital goods and intermediates (especially iron and steel); and, (5) imports of food, edible oil and fibre to contain inflationary pressures. The increased current account deficit arising from these policies was financed through a variety of short- and medium-term facilities of the IMF as well as workers' remittances. These policies, and other developments, left the economy with (a) more effective control over the rate of inflation; (b) some deceleration in industrial growth in 1979-83, due to a combination of import competition and infrastructural bottlenecks; (c) a decline in the rate of real gross investment, due partly to lack of buoyancy in private investment; (d) halting progress towards a more internationally competitive industrial structure; and, (e) a much faster increase in imports compared to export earnings. Overall, the economy has not reaained the growth momentum attained prior to 1964-65; furthermore recent growth has been dominated by the tertiary sector alone. II. CONCLUSIONS The above narrative suggests a number of hypotheses which have been examined in our study of adjustment to shocks during this period. - iii -  First, what net impact did external shocks and the policy response to them have on investment and growth? This is answered by examining the consequences of removing external shocks and particular accomodating policies deemed to be pursued in response to those shocks, while keeping remittances unchanged at their 1973-74 level. It is seen that accommodating borrowing from the IMF and various oil-related development institutions after the first oil shock and the Extended Fund Facility with the IMF after the second oil shock more than offset the deleterious impact of terms of trade movements. GDP, private consumption and investment would have been lower in the no external shock-cum-accommodating borrowing scenario: indeed the capital stock in 1984-85 and would have been 8 percent lower. Domestic production of consumer good, and infrastructure would have gone up at the expense of capital goods. This would to some extent have intensified rather than allayed concerns that have been expressed about the stagnation of investment compared to the pre-1964-65 years. However, as expected, the debt burden would also have been lower - by nearly 48 percent at the beginning of 1983-84. Second, what would have been the consequences of stepping up investment in response to the first oil shock and containing potentially inflationary pressures through imports of essential consumer goods? The higher investment would have led to a capital stock in 1984-85 which was nearly 2 percent higher than in the historical run. GDP and private consumption were also higher. Domestic production of capital goods would have gone up at the expense of infrastructure and consumer goods. In the absence of any other measures, however, the economy would - iv -  have been left with a 27 percent higher stock of debt by the beginning of 1983-84. Third, how would the economy have developed in the absence of exogenous agricultural shocks? The peaks and troughs in GDP, consumption, and investment in this policy experiment mirrored those in the exogenous variable which proxied weather-related fluctuations. Thus, the above macroeconomic variables would have been higher if weather-related dips had not occurred; their behavior would have been the opposite in the absence of weather-related peaks. The 1984-85 capital stock would also have been lower - by 6.5 percent - under the no agricultural shock scenario. The assumed connection between agricultural shocks and the preceived need to effect deflationary adjustment makes it instructive to ask what a "no agricultural shock- cum-deflationary adjustment" would have implied for the economy. This, however, simply involves adding the present experiment to the previous one. It is an obvious counterpart to the "no external shock-cum- borrowing" experiment, described above. Reference has already 'cen made to the stagnation of investment in the 1970s in historical perspective. The first experiment reported above shows that investment would have been lower than in the historical run in that case. This indicates that external shocks and accommodating borrowing were not directly responsible for the deceleration in investment: indeed the opposite is true. Furthermore, the no- agricultural shock scenario, when run from 1973-74 to 1983-84, would also have resulted in lower investment and terminal capital stock. - v -  However, in as much as the demand-deflationary measures of 1974-75 and 1975-76 were prompted by agricultural shocks and their potential for generating inflation, it is possible that investment would have been higher than in the historical run on a "no agricultural shock-cum- deflationary adjustment" counterfactual. This line of argument suggests that the stabilization program designed to curb inflation contributed to the stagnation of investment in the 1970s. Fourth, what would have been the economywide impact of following a less cautious policy on reserve accumulation, i.e.9 using ".excess" reserves to finance higher investment and imports during 1976- 77 to 1979-80? Specifically, reserves are decumulated in the years 1976-77 to 1979-80 to four months' level of imports in a "bold" scenario and at six months' level of imports in a "conservative" scenario; the resulting differences with actual reserves are added to foreign savings. This generates a substantially higher profile of GDP, private consumption and investment, leading to a nearly 3 percent increase in the capital stock by 1980-81, an increase in produetion of capital goods and infrastructure at the expense of consumer goods and some widening in urban-to-rural per capita income levels. Since "excess" reserves were available in those years, they would have allowed the economy to sustain a less deflationary adjustment strategy of the kind formulated in the last experiment. However, since the extra foreign savings would have come out of reserves rather than fresh borrowing, the debt burden would have been lower than in the previous experiment. The question could be answered by combining the themes of those two policy experiments. - vi -  Fifth, would adjustment based on a different sectoral allocation of investment have led to markedly superior outcomes in terms of arowth and the balance of payments? A seemingly plausible but myopic policy of allowing investment allocation to take advantage of sectoral differences in current profitability is implemented. This leads to higher GDP and private consumption and a capital stock which is 1.7 percent higher in 1984-85 compared to the historical run, while pulling resources out of nontradeables and towards the tradeable sectors of the economy. But it also leaves the economy with a stock of debt which is 27 percent higher at the beginning of 1983-84. This is the result both of higher import intensity of sectors towards which investment is redirected, as well as an increase in domestic demand pressure and a consequent bidding up of domestic vis-a-vis international prices. This experiment, however, is only a start towards examining the question of how investment is best reallocated among sectors in response to exogenous shocks. Finally, an interesting feature of all the policy simulations is the virtually uniform impact on all groups of households. Indeed, there is hardly any movement in the Gini coefficient of income or consumption inequality. The cost of living indices do not move significantly differently for the ten aroups of households separately identified by the model. Nor is there any movement in the share of the bottom 40 percent in income and consumption. Thus, the impact of the alternative policies described above on the size distribution of income and consumption is not significant. These remarks, however, do not necessarily apply to the regional or functional distribution of income. - vii -  Chapter 1: OVERVIEW I. T1TRODUCTION This paper (1) analyses and interprets the adjustment of the Indian economy to the twin exogenous shocks of oil price increases and harvest failure during the period 1973-74 to 1983-84 (chapter 1); (2) implements a six-sector economywide general equilibrium model to a consistent data set for 1973-74 (Chapter 2 and Appendices 1 to 4); (3) uses the model to approximate the principal developments in the Indian economy during 1973-74 to 1983-84 (Chapter 3); (4) explores the consequences for the macroeconomic aggregates, intersectoral resource allocation and income distribution of different policy packages for adjusting to various kinds of shocks (Chapter 4); and (5) summarizes the main conclusions (Chapter 5). Chap-I(India Shocks):4-11-86:pp  -2- TI. ADJUSTMENT TO SHOCKS. GENERAL CONSIDERATIONS Every erzonomy is subject to certain exogenous shocks which disturb the growth process or accentuate the constraints operating upon that process. Weather-induced failure of the agricultural harvest in predominantly agrarian economies is an example of an internal exogenous shock. Sudden emergence of war abroad which interrupts the supplies of certain essential commodities in an open economy is an example of an external exogenous shock. By contrast, an example of a policy-induced (and hence not exogenous) shock is provided by profligate government spending or, in some cases, excessively tight demand management. Furthermore, within these two categories of shocks, i.e., exogenous and policy-induced, it is possible to distinguish between temporary and permanent shocks. The mode of adjustment to an exogenous shock depends on the perception of the policy-makers regarding its nature. A shock which is perceived to be transient in nature may call for borrowing (as with a temporary shortfall in export earnings) a change in the monetary-fiscal policy mix (if priority attaches to containing inflationary pressures arising from a poor harvest, but without deleterious effects on investment) or a temporary reallocation of available supply outside tha market mechanism. On the other hand, longer-term adjustment is deemed necessary if the shock is perceived to be persistent in nature (for example, increased oil price or a secular slowdown in productivity growth in the industrial countries). Chap-l(India Shocks):4-11-86:pp  -3- The ability of an economy to respond to exogenous shocks without seriously compromising its growth prospects depends on (1) initial conditions, e.g., its agrarian or non-agrarian character, the extent of its dependence on international trade and the facility with which resources can be shifted across uses; (2) the appropriateness of the economy's perception of the nature of shocks; and (3) the policies adopted and the relative weight of those affected by such policies. This chapter analyzes and interprets the adjustment of the Indian economy to exogenous external shocks in the form of two steep oil price increases in the seventies and their repercussions. In the Indian context, both the external shocks coincided with the internal exogenous shock of harvest failure and the policy response was aimed at adjusting to both the shocks simultaneously. In the review of actual adjustment, therefore, it is not always possible to separate out policies aimed at the two shocks. Furthermore, in as much as end-results in the form of certain performance indicators are shaped by policies as well as exogenous forces, an assessment of their relative roles requires the exercise of some judgement. With these general considerations, the next section (Section III) reviews the developments in the Indian economy prior to the Chap-l(India Shocks):4-11-86:pp  -4- external shocks. This provides a perspective against which the developments in the adjustment period can be placed. Section IV is devoted to the discussion of the first oil shock of 1973 and the adjustment to it during the period from 1973-74 to 1978-79. Section V examines the period of the second oil shock of 1979, from 1979/80 to 1983/84. An overall assessment is presented in Section VI. - Ut. TnDAt ECONOMY BEFORE 1973-74: A PERSPECTIVE The Indian economy can be characterized as a densely populated, low income, large and predominantly agrarian economy. GenerrLly, relatively limited reliance on international trade marks the large economies - defined in terms of population and diversified natural resources - from the average of all developing countries. 1/ In the context of the Indian economy, this limited reliance on foreign trade had been further restricted by the strategy of import- substitution-led industrialisation that was adopted possibly in the light of 'export-pessimism' prevailing in the nineteen-fifties. Recurrent foreign exchange crises -- arising partly out of the adopted policy package itself - further strengthened the import and foreign exchange restrictions of various kinds. These restrictions, combined with an overvalued exchange rate provided protection to domestic producers of import-competing products and, notwithstanding certain ad / See Chenerv, H. B. (1982), "Industrialization and Growth: the Experience of Large Countries," World Bank Staff Working Paper, Number 539.  -5. hoc concessions, discriminated against exports.-L During this period, foreign assistance substituted for export expansion as a source of foreign exchange. While import restrictions protected domestic producers from international competition, industrial licencing restricted entry of other domestic producers and prevented the emergence of internal competition. This constellation of policies gave rise to a diversified yet a highly protected industrial structure and an economy that was effectively instulated from the international environment. In this situation, the exogenous shocks interrupting the growth process were of two kinds: the weather-induced failure of agricultural harvests and unexpected cuts in foreign assistance. The former could trigger an inflationary price spiral in a virtually closed and predominantly agrarian economy whereas the latter could lead to significant cuts in public investment. The growth process that was initiated in the early-fifties was broken by two successive droughts in the agricultural years (July-June) 1965/66 and 1966/67, together with a cessation of American foreign aid following the war with Pakistan in 1965. A comparison of the trend / For a discussion of the policies and their consequences, see J. N, Bhagwati and P. Desai: India: Planning for Industrialisation, Oxford University Press, London, (1970). J. N. Bhagwati and T. N. Srinivasan: Foreign Trade Regimes and Economic Development: India, National Bureau of Economic Research, New York (1975) I. Little, T. Scitovsky and M. Scott: Industry and Trade in Some Developing Countries: A ComDarative Study, Oxford UTniversity Press, London (1970)  - 6 - growth rates over the period from 1950/51 to 1964/65 (period I) with those over the period from 1964/65 to the onset of the first oil crisis in 1973-74 (period II) is presented in Table 1.1 for a number of macro- variables. This comparison indicates that period II covering a decade prior to the first oil crisis is marked by a deceleration in the trend rate of growth of almost all the macro-variables. The only sectors which register a higher growth rate in period II than in period I are (a) GDP in Agriculture (line 3); (b) the primary sector of which agriculture is a dominant component (line 6); (c) finance and real estate (line 10); and (d) public administration and defence (line 12). Among the remaining macrovariables there was a virtual stagnation in period II in gross fixed capital formation in the public sector as also gross investment going into registered manufacturing (for which trend growth is not given in Table 1.1). A sharp deceleration in the trend growth rate is experienced by the following: gross investment in total (registered plus unregistered) manufacturing (line 16), gross domestic as well as fixed capital formation-L (lines 13 and 14), and GDP originating in registered as well as total manufacturing (lines 4 and 5). It should thus be obvious that period II was generally marked by a much lower trend growth rate than period I. / Trend growth rates are not indicated for these items for period II because the levels were virtually stagnant during the period.  -7- The recurrent harvest failures and their adverse implications for wage-good availability and the resulting constraint on the growth process had indeed been perceived in the late fifties. Conseqtuently, self-sufficiency in foodgrains featured for the first time as one of the major objectives of the Third Five Year Plan formulated in 1960. The programs for intensive development of crop output by concentrating on selected favorably placed regions were initiated in the early sixties. The immediate response to the two successive droughts of the mid-sixties consisted of foodgrains imports under PL480. Simultaneously, certain steps were also initiated towards stabilising and stepping up of domestic output of grains through the extension of irrigation and the incentives for the adoption of chemical-biologicaL technology. Consequently, the trend growth rate of GDP originating in agriculture could be marginally stepped up from 2.40 percent in period I to 2.79 percent in period II. Despite greater variability around a higher trend growth rate, the achievement can be regarded as remarkable as it occurred in the face of deceleration in the growth of net sown area. Adjustment to the abrupt cessation of foreign assistance took the form of a cut in public investment in particular and a decline in the rate of gross domestic investment in general. The net result of both the shocks is reflected in a slow-down in the trend growth rate of aggregate GDP from 3.85 percent to 3.32 percent and of per capita GDP from 1.86 percent to 1.08 percent, with a much hiaher variability around the trend growth rate in period II than in period T,  IV. ADJUSTMENT TO THE FIRST OIL SHOCK OF 1973/74 Before the onset of the first oil shock in 1973, the peak agricultural harvest of 1970-71 was followed by a slight reduction in 1971-72 and a severe drought in 1972-73 when real income originating in agriculture declined by 6.36 percent compared to the previous indifferent harvest. The influx of refugees from what was then East Pakistan, resulting in the creation of Bangladesh, in 1971 led to a steep rise in defence expenditure. Consequently, the annual rate of inflation -/ as measured by the wholesale price index accelerated progressively from 2 percent around April 1971 to about 17 percent by September 1973 the beginning of the oil price hike. The oil price more than auadrupled from ITSS2.70 per barrel in September 1973 to UJSS11.20 per barrel in March 1974. Simultaneously, the agricuiltural harvest of 1973-74 managed only to restore the real income in agriculture to the peak of 1970-71 only to dip marginally again in 1974-75. The internal and external shocks together accentuated the inflationary tendencies which had been accumulating since '972. The annual inflation rate increased further from 17 percent in September 1973 to the highest ever rate of nearly 34 percent by September 1974. Reading through the Economic Surveys of this period from the tinistry of /The estimates of annual rates of inflation auoted here, and subsequently, are based on the chart of annual rates of inflation from April 1971 to October 1983 appearing between pages 36 and 37 in the Economic Survey 1983-84 published by the Government of India.  Finance, one gets the impression that the policy-makers perceived the internal shock resulting from downward variations in agricultural harvest, and not the oil price increase, to be the primary cause of the inflationary pressures. In fact, the oil price increase was perceived to be a mere aberration that was unlikely to persist and hence treated as a purely transient phenemenon requiring only short-term adjustment. As a consequence of the oil price increase, import outlays on POL (petroleum, oil, lubricants) shot up from Rs 207 crores in 1973/74 to Rs 541 crores in 1973/74 and more than doubled in 1974/75 to reach Rs 1246 crores - an increase of 132 percent per annum over two years. Relative to this high base, the growth rate over the next three years 1975/76 to 1978/79 was reduced to less than 11 percent per annum. It is worth noting that imports of crude, as well as petroleum products, in physical terms increased at the rate of 10 to 11 percent per annum between 1975/76 and 1978/79 -- more or less in line with import outlays. In contrast, between 1972/73 and 1974/75, import outlays more than quadrupled although in physical units, the growth rate of crude imports was 7.7 percent per annum whereas imports of petroleum products declined at the rate of 13.33 percent per annum. -/ 1/ The statements in this paragraph are based on figures available in various Economic Surveys published by the Ministrv of Finance, Government of India.  Table 1.1 Trenid Rate of Growth Per Annum for Selected Periods and Items Period I Period II 1950-51 1964-65 gighest ROG Observed Over to to 1964-65 to 1.98'-82 1964-65 1973-14 2 Item ROG (5%) 2 ROG (%) r ROG M r Period (2) (3) (4) (5) (6) (7) (8) (9) 1. Aggregate CDP 3.85 O9891 3.32 0.9003 3.59 0.9777 1964-65 to 1983-84 2. Per Capita CDP 1.86 0.9614 1.08 0.4836 1.34 0.7811 1964-65 to 1978-79 1.34 0.8505 1964-65 to 1983-84 3. GDP ivx Agriculture 2.40 0.9208 2.79 0.6120 2.84 0.8163 1964-65 to 1978-79 4. CDP in MIfg. (Total) 6.75 0.9884 3.47 0.9294 4.08 0.9642 1964-65 to 1979-80 4.08 0.9745 1964-65 to 1981-82 5. GDP in Mfg. (1Regtd.) 7.98 0.9806 3.78 0.8839 4.27 0.9652 1964-65 to 1981-82 C 6. CG)P in Primary sector 2.50 0.9370 2.78 0.6509 2.82 0.8383 1964-65 to 1978-79 H 7. GDP in Secondary secror 6.67 0.9794 3.53 0.9732 3.92 0.9646 1964-65 to 1978-79 0.9707 1964-65 to 1979-80 8. CDP in Tertiary sector 4.87 0.9897 4.01 0.9951 4.72 0.9890 1964-65 to 1981-82 9. CDP in Trade & Communicatilons 5.78 0.9877 3.94 0.9901 4.76 0.9863 1974-65 to 1981-82 10. GDP in Fi:nance & Real Estate 3.94 0.9898 4.58 0.9928 4.57 0.9845 1964-65 to 1979-90 11. CDP in Community and 4.06 0.9900 3.79 0.9867 4.75 0.9733 1964-65 to 1981-82 Personial Services 12 GDP in Public Administration 6.26 0.9602 6.50 0.9885 7.13 0.9863 1964-65 to 1981-82 13. Cr Fixed Cap. Formation (GFCF) 6.68 0.8795 4.12 0.9389 1964-65 to 1978-79 14. Cr. Dom. Cap. Formation (GDCF) 7.16 0.8026 4.87 0.9625 1964-65 to 1978-79 15. Public Sector GFCF 11.40 0.9762 4.20 0.7880 1964-65 to 1981-82 16. Gr. Inv. Mfg. (destination) 10.52 0.6149 3.40 0.2899 5.25 0.7465 1964-65 to 1981-82 17. Gr.Iniv.Regd.Mlfg.(destiinatiotn) 10.55 0.5260 -0.30 0.0024 6.83 0.1475 1964-65 to 1977-78 Note: 1. Cross fixed capital format:ion and gross domestic capit:al formatiotn (rows 13 anid 14) are measulred at 1960-61 prices. All ot:her Itlems are at 1970-71 prices 2. R05 (%) = tretnd rate of growth ini percent. pet annutim. r=squared correlation. coefficienit between time and the logarithmic tranisform of the variable listed in columni (2). 3. Trentd rate of growth is given by thie coefficietit oF the tinme variable when logarithmic transformv of a givent variable (columni (2)) is regressed agailnst time.  In relation to export earnings, POL imports amounted to 10.35 percent in 1972/73. This share more than doubled in 1973/74 to 22