India - Five years of stabilization and reform and the challenges ahead

___ A WORLD BANI COUNTRY STUDY India Five Years of Stabilization and Reform and thle Chlallenges Ahead   A WORLD BANK COUNTRY STUDY India Five Years of Stabilization and Reform and the Challenges Ahead The World Bank Washington, D.C.  Copyright i 1996 The International Bank for Reconstruction and Development/ THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing December 1996 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. 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The World Bank encourages dissemination of.its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. For a copy of Update describing new publications, contact the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or Publications, The World Bank, 66, avenue d'Ina, 75116 Paris, France. A catalog and ordering information are also available on the Intemet at http://www.worldbank.org. ISSN: 0253-2123 Library of Congress Cataloging-in-Publication Data India : five years of stabilization and reform and the challenges ahead. p. cm. - (A World Bank country study) "Prepared by a team led by Zoubida Allaoua"- P. vii. Includes bibliographical references. ISBN 0-8213-3838-2 1. India-Economic policy-1980. 2. India-Economic conditions-1947- I. Allaoua, Zoubida. II. World Bank. III. Series. HC435.2.1532 1996 338.954-dc2l 96-48266 CIP  - 111 - TABLE OF CONTENTS ABSTRACT ............................................................... vii ACKNOWLEDGMENTS ............................................................... v.ii ABBREVIATIONS AND ACRONYMS ............................................................... ix CURRENCY ................................................................ xi ECONOMIC DEVELOPMENT DATA ............................................................... xii EXECUTIVE SUMMARY ............................................................... xvii PART I: FIVE YEARS OF STABILIZATION AND REFORM: A SUMMING UP .........................I CHAPTER 1: FROM CRISIS TO GROWTH ..................... ...........................................3 Introduction ................................................................3 Macroeconomic Developments .................................................................6 An Unexpectedly Strong Recovery ................................................................6 Inflation Declined But Monetary Management Became More Complex ...................... 11 The Extemal Accounts Improved Significantly ............................................................ 16 Fiscal Adjustment is One Area of Serious Concen ........................................... 16 Fiscal Adjustment in the 1996-97 Budget ........................................... 21 Progress in Structural Reform ........................................... 24 Perspectives From the Poor ........................................... 27 CHAPTER 2: MACROECONOMIC VULNERABILITIES AND STRUCTURAL WEAKNESSES ................................................. 33 Introduction ................................................. 33 Macroeconomic Vulnerabilities ................................................. 34 Fiscal Vulnerabilities .................................................. 34 External Account Vulnerabilities ................................................. 36 Structural Weaknesses ................................................. 37 Conclusion ................................................. 50 PART II: THE CHALLENGES AHEAD ................................................. 51 CHAPTER 3: THE CENTRALITY OF FISCAL ADJUSTMENT ................................................. 53 Introduction .................................................5 3 Extent and Nature of India's Fiscal Imbalances ................................................. 53 Essential Elements of a Fiscal Adjustment Strategy .................................................. 3 Expenditure Reform ................................................. 59 Tax Reform .................................................. 62 Restructuring Center-States Fiscal Relations .................................................. 65 Financial Sector Reforms and Capital Market Development .................................................. 67  - iv - CHAPTER 4: UNLEASHING AGRICULTURE'S GROWTH POTENTIAL ................................ 77 Overview ..................................................................... 77 Public Expenditure: Remaining Issues .................................... ................................. 79 Public Expenditure Reform ..................................................................... 84 Foreign Trade De-Regulation .................................................................... 88 Domestic Trade De-Regulation .................................................................... 90 Rural Credit Reform ..................................................................... 97 CHAPTER 5: THE ENABLING FRAMEWORK FOR PRIVATE INVESTMENT IN INFRASTRUCTURE .................................................................. 99 Introduction .............................................................. 99 Power ............................................................... 100 Private Investment in Generation .......................... .................................... 100 Private Sector Participation in Distribution .............................................................. 103 Transport .............................................................. 105 Introduction .......................................................................................... 105 Improving Competition and Efficiency .............................................................. 105 Facilitating Private Sector Investment in Fixed Transport Assets .............................. 109 Telecommunications .............................................................. 112 Introduction ............................................................... 112 Outstanding Issues .............................................................. 114 Conclusion ............................................................... 114 CHAPTER 6: EXTERNAL PROSPECTS AND FINANCING REQUIREMENTS ..................... 117 Introduction .................................................................... 117 External Economic Environment and Implications for India .................................................... 117 Prospects for Higher Growth and Exports ..................................................................... 121 Prospects for Selected Key Export Sectors ................................................................ 122 Prospects for Selected Key Service Exports ............................................................... 124 External Financing Requirements ..................................................................... 126 SELECTED REFERENCES ..................................................................... 129 ANNEXES I Methodology and Key Assumptions for Estimating Savings from Privatization ...... 131 II A Summary of the Computable General Equilibrium Model ..................................... 133 Ill Executive Summaries of Beneficiary Assessment Surveys ........................................ 135 STATISTICAL APPENDIX ..................................................................... 159  LIST OF TABLES 1.1 Growth Performance 1981-96 .........................................................89 6 .6 1.2 Index of Industrial Production, 1981-95 ..........................................................6 1.3 Change in Trade Orientation, Profitability, and Productivity since 1991, Compared to the pre-1991 Period .7 1.4 Change in Profitability, and Productivity since 1991, Compared to the pre-1991 Period ..........................................................8 1.5 Foreign Direct and Portfolio Investment ...........................................................9 1.6 Domestic Demand, 1981-95 .......................................................... 10 1.7 Selected Monetary Indicators, 1990-96 ......................................................... 12 1.8 Real Exchange Rate of India's Main Trading Partners and Competitors, 1981-96 ..................... 12 1.9 Balance of Payments, 1991-96 ......................................................... 15 1.10 Evolution of the Public Deficit, 1990-96 .......................................................... 17 1.11 Key Interest Rates, 1990-96 ......................................................... 18 1.12 Central Government Finances, 1990-97 ......................................................... 19 1.13 State-Wise Shares of Marginal and Small Farmer Holdings ....................................................... 31 2.1 Gross National Savings for Selected East Asian Countries and India, 1992; 1994 ...................... 35 2.2 Total Public Expenditure, Regional Comparison ......................................................... 35 2.3 Fiscal Balances, Consolidated Government Fiscal Deficits ........................................................ 36 2.4 Scientific and Technical Workers ......................................................... 43 2.5 International Comparison of Airport Capacity ......................................................... 46 2.6 Telecommunications Sector Indicators, 1993 ......................................................... 47 3.1 Evolution of the Public Debt Stock, 1990-96 ......................................................... 54 3.2 Interest Rates and Payments on Public Debt ......................................................... 54 3.3 International Comparison of Public Debt Stocks and Interest Payments .................................... 55 3.4 The Primary Deficit Consistent with Solvency ......................................................... 56 3.5 Fiscal Consequences of Financial Reform ......................................................... 56 3.6 Net Impact of SEB Performance on 14 State Budgets, 1991-1995 ............................................. 61 3.7 Estimated Additional Public Savings .......................................................... 65 4.1 Economy-wide Reforms are Removing the Anti-Agricultural Bias ............................................ 77 4.2 Agricultural Price Movements, A Decomposition Analysis ....................................................... 78 4.3 India Spends Twice as Much on Agriculture as East Asian Countries ........................................ 79 4.4 Growth Prospects Suffer Most Among Poor States ......................................................... 82 4.5 Improved Composition of Expenditure Could Compensate for the Removal of Input Subsidies .................................................... 84 4.6 Trade Reforms in Indian Agriculture .................................................... 88 4.7 Evaluating Alternative Policies for Raising Relative Agriculture Prices .................................... 89 4.8 Value of Output from Agriculture ..................................................... 90 4.9 Beyond Trade Policy, What are the Problems with Agricultural Markets? ................................ 90 4.10 What Causes the Problems with Agricultural Markets? .................................................... 91 6.1 Exte rnal Environment for India, 1975-2005 .................................................... 118 6.2 Sources and Growth of India's Foreign Exchange Earnings .................................................... 119 6.3 Performance of Key Export Sectors .................................................... 120 6.4 Foreign Tourism in India and Comparators .................................................... 126  - vi - LIST OF BOXES 1.1 India's Social Profile ...........................................................4 1.2 Four Stylized Facts Seem to Emerge From the States as a Result of the Central Government Stabilization and Adjustment Program ............................................... 20 1.3 The Common Minimum Program of the United Front Government ........................................... 22 1.4 Reforms in the 1996-97 Budget ................................................ 23 1.5 Capital Market Reforms Led to Improvement in Transparency, Reliability and Fairness of Transactions .................................................. 26 1.6 Did India's Macroeconomic Stabilization Increase Poverty in 1992? ........................................ 28 1.7 Selected Case Studies: The Impact of Economic Reforms on the Poor ..................................... 30 2.1 Spillover Effects of FDI .................................................. 38 2.2 Are Potato Chips More Important Than Computer Chips? .................................................. 40 2.3 The Success Story of India's Maruti Udyog .................................................. 41 2.4 Haryana's Power Crisis .................................................. 48 3.1 Welfare Consequences of Selling Public Enterprises .................................................. 60 3.2 Liquidation of Manufacturing Sick Enterprises .................................................. 61 3.3 Net Transfer of Resources from the States to the SEBs .................................................. 62 3.4 Mexican Corporate Assets Tax .................................................. 64 3.5 The States of Maharashtra and Rajasthan are Leading the Way in Sales Tax Reforms .......................... 64 3.6 Reform of States' Sales Tax .......................... 66 3.7 Benefits of an Efficient Money Market ........................... 68 4.1 Correcting for India's Large Size Reduces Significantly the Apparent Policy Bias Against Agriculture .......................................................... 78 4.2 Budgeted Subsidies to Indian Agriculture .......................................................... 80 4.3 Institutional Reforms in Karnataka's Irrigation Sector ......................................................... 86 4.4 Deficiencies in Port and Port Services Impede Agricultural Exports .......................................... 92 5.1 Multiple Efforts to Encourage and Expedite Private Investment in BOT Projects ................... 111 5.2 A Large Unmet Demand for Telecommunication Services Persists ......................................... 113 LIST OF FIGURES 2.1 Comparative Clothing Production Costs, 1995, DMlstandard minute ........................................ 42 2.2 Infrastructure Stocks and per capita GDP .......................................................... 44 2.3 Rail Road Tracks ......................................................... 46 3.1 Call Rate, Weekly High and Low ......................................................... 70 3.2 Daily Average Call Rate, July-September 1995 (DFHI) .......................................................... 70 3.3 Debt and Liquidity Management, Reserve Bank of New Zealand .............................................. 73 3.4 91 Day T-Bills ......................................................... 73 4.1 Agricultural Terms of Trade Recover from Policy Bias ......................................................... 77 4.2 Subsidies Crowd-Out Productivity-Enhancing Expenditures During the 80s ............................. 79 4.3 Capital Formation in Indian Agriculture is Declining ......................................................... 81 4.4 Irrigation Related Subsidies Dominate Agricultural Subsidies ................................................... 81 6.1 Export Market Share for India and Competitors .......................................................... 119 6.2 SITC 667 Pearls, Precious and Semi-Precious Stones ......................................................... 123  - vii - ABSTRACT The stabilization and reform measures introduced over the past five years have considerably improved India's growth prospects. Growth accelerated to over 6 percent in 1995-96 from less than one percent in 1991-92. The progressive integration of the Indian economy into the global economy with the liberalization of the investment, trade and foreign exchange regimes has improved productivity, particularly in the industrial sector, which has been growing at rates exceeding 10 percent in the last two years. In addition, the exchange rate devaluation and the reduction in the level of protection of the industrial sector have been beneficial to agriculture. Growth is now driven by exports and private investment, and is being accompanied by an increase in domestic savings. At US$2 billion in 1995-96, foreign direct investment is 15 times higher than it was before the economy was liberalized and portfolio investment has stabilized at around US$2- 3 billion--that is 10 percent of world portfolio investment in emerging markets. Inflation has declined and the external accounts have strengthened. Notwithstanding these remarkable achievements, this report, like the Government's June 1996 Common Minimum Program and the Ministry of Finance 1995-96 Economic Survey, re- emphasizes the importance of urgently addressing the remaining structural constraints to higher growth. Chief among them are: reducing the country's chronically high fiscal deficits; removing the remaining investment and trade restrictions, particularly in agriculture; averting a crisis in infrastructure; and strengthening the country's human capital base.  - viii - ACKNOWLEDGMENTS This Memorandum was prepared by a team led by Zoubida Allaoua. It draws on contributions from Paul Beckerman (monetary and financial sector developments and policies); Uri Dadush, T.G. Srinivasan, Milan Brahmbhatt and Kim Murrell (India in the global economy); Xinghai Fang, IFC, (private infrastructure financing); Mona Haddad (balance of payments); Dinanath Khatkhate and Lystra Antoine (public savings); Sanjay Kathuria (recent macroeconomic developments); Valerie Kozel (beneficiary assessments); Norman Loayza (savings); William McCarten (recent fiscal developments and tax reform); Luis Serven (fiscal deficit and public sector solvency); Donald Mclsaac (insurance sector and other contractual savings institutions); Djamal Mostefai and Mohinder Gulati (impact of power subsidies on states finances); Dan Mozes (mutual funds); Martin Ravallion and Gaurav Datt (poverty); Clemencia Torres (contribution of central public enterprises to public savings), with guidance from Ahmad Galal; David Wilton (money and bond markets); Fahrettin Yagci (industrial sector performance); and Dimitri Tzanninis, IMF (current expenditure reform). The primary author of chapter 4 was Benoit Blarel drawing on contributions from Dina Umali-Deininger, Garry Pursell, Jaime Quizon and Manoj Panda. Hans Binswanger (Senior Adviser) was the lead advisor for this chapter. The primary author of Chapter 5 was Colin Bruce drawing on contributions from Joelle Chassard (legal regulatory and administrative issues in the power sector); Mohan Gopal (legal framework); Harald Hansen and Ernst-August Huning (financial, institutional, legal and regulatory issues in the transportation sector); and Hugh Lantzke (legal, regulatory and administrative issues in the telecommunications sector). Robert Burns advised on urban and general infrastructure issues. Primary statistical and computational assistance was received from Maria Almero-Siochi, Rajni Khanna and Bhaskar Naidu. Background studies for the CEM were also prepared by NCAER (impact of economic reforms on large, medium and small scale enterprises in the organized and unorganized sectors), Pullapre Balakhrishnan (savings rate in India since 1991, and economic reforms and productivity growth in India), Tata Energy Research Institute (impact of power subsidies on states finances), and Ajit Ranade and Mahendra Dev of IGIDR (public expenditure in agriculture). Beneficiary assessment surveys were carried out by Ravi Srivastava, Nisha Srivastava, Madhavi Kuckreja, N. Thangaraj, Sarthi Acharya and S.S. Gill. Financial support for these surveys was provided through a Trust fund set up by the Netherlands Government. Arrangements for missions to India were made by Padma Gopalan and Sheni Rana. Production assistance was provided by Lin Chin who was aided by Zelena Jagdeo and Naomi Dass. Uri Dadush (Division Chief) and Roberto Zagha (Lead Economist) were initial reviewers before becoming direct contributors to the report. Robert J. Anderson (Lead Economist) was reviewer for the whole report and Amarendra Bhattacharya (Economic Adviser) for chapters 2 and 3. Rui Manuel Coutinho (Acting Chief Economist for the South Asia Region) reviewed the report and provided general guidance. The document was prepared under the supervision of Luis Ernesto Derbez (Division Chief) and Roberto Zagha (Lead Economist). We gratefully acknowledge the cooperation of government officials, in particular the staff of the Department of Economic Affairs and the RBI as well as members of the private business community. The document was discussed with the Indian authorities during July 25-29, 1996.  - ix - ABBREVIATIONS AND ACRONYMS AAI Airports Industry of India FCNRA Foreign Currency (Non-Resident) ADB Asian Development Bank Accounts AMT Alternative Minimum Tax FCNRB Foreign Currency (Non-Resident) APEC Asia Pacific Economic Cooperation Accounts Bank Scheme BE Budget Estimates FCON Foreign Currency (Ordinary) Non- BEL Bharat Electronics Limited Repatriable Deposit Scheme BHEL Bharat Heavy Electricals Limited FDI Foreign Direct Investment BIFR Board for Industrial and Financial Fll Foreign Institutional Investor Reconstruction FOB Freight On Board BKU Bhartiya Kisan Union FRN Foreign Rate Notes BO Butter Oil FSU Former Soviet Union BOLT Build-Operate-Lease-Transfer GATT General Agreement on Tariffs and Trade BOP Balance of Payments GDP Gross Domestic Product BOT Build-Operate-Transfer GDR Global Depository Receipts BSE Bombay Stock Exchange GIC General Insurance Company CEA Central Electricity Authority GNFS Goods and Non-factor Services CEM Country Economic Memorandum GNP Gross National Product CES Constant Elasticity of Substitution GOI Government of India CFS Container Freight Station HMT Hindustan Machine Tools CGE Computable General Equilibrium HSEB Haryana State Electricity Board CIA Central Information Agency HYV High Yielding Varieties CIF Cost Insurance and Freight ICAR Indian Council of Agricultural Research CMP Common Minimum Program ICC International Chamber of Commerce CONCOR Container Corporation of India ICD Inland Container Depot CPE Central Public Enterprises ICDS Integrated Child Development Scheme CPI Consumer Price Index iCICI Industrial Credit and Investment CPIAL Consumer Price Index for Agricultural Corporation of India Laborers ID Irrigation Departments CRR Cash Reserve Requirement IDBI Industrial Development Bank of India CSI Contractual Savings Institutions IDF Indian Development Forum CSO Central Statistical Organization IDFC Infrastructure Development Finance DAP Di-Ammonium Phosphate Company DDP Desert Development Program IFCI Industrial Financial Corporation of India DFHI Discount Finance House of India IFPRI International Food Policy Research DGCA Directorate General of Civil Aviation Institute DGCIS Directorate General of Commercial lIP Index of Industrial Production Intelligence and Statistics IMF International Monetary Fund DM Deutsche Mark INS Information Notice System DOT Department of Telecommunications IPP Independent Power Producers DPAP Drought Prone Areas Program IRBI Industrial Reconstruction Bank of India DRS Debt Reporting System IRDP Integrated Rural Development Program EAS Employment Assurance Scheme IS Import Substitution Strategy EC Essential Commodities Act ISIEC Indian Sugar and General Industries ECA Europe and Central Asia Import and Export Corporation ECB Euro-Convertible Bond ISO International Standards Organization ED Electricity Duty IT Information Technology EDI Electronic Data Information JRY Jawahar Rozgar Yojana EGF Employment Generation Fund KSA Kurt Salmon Associates EGS Employment Guarantee Scheme Kwh Kilowatt-hour EP Export Promotion Strategy LAC Latin America and the Caribbean EPF Employees Provident Fund LES Linear Expenditure System EPTD Environment and Production Technology LIBOR London Inter-Bank Offer Rate Division LIC Life Insurance Company EU European Union (formerly the EC) M&A Mergers and Acquisitions FCBOD Foreign Currency (Banks & Others) MAT Minimum Alternate Tax Deposits MFA Multifiber Agreement FCCB Foreign Currency Convertible Bonds MMF Man Made Fibers FCI Food Corporation of India MMMF Money Market Mutual Fund MMPO Milk and Milk Products Order  MNA Middle East & North Africa RFC Resident Foreign Currency Account MNC Multinational Corporation RFI Regional Financial Institutions MNE Multinational Enterprises RFP Request for Proposals MODVAT Modified Value Added Tax RLDC Regional Load Dispatch Center MOF Ministry of Finance RLEGP Rural Landless Employment Guarantee MoP Muriate of Potash Program MOP Ministry of Power RPDS Revamped Public Distribution System MOST Ministry of Surface Transport RRB Rural Regional Bank MOU Memorandum of Understanding SAIL Steel Authority of India Ltd. MPBF Maximum Permissible Bank Finance SAM Social Accounting Matrix MRTP Monopolies and Restrictive Trade SAP State Advised Price Practices Act SBI State Bank of India MTM Mark to Market SC Scheduled Castes MTO Multimodal Transport services SCICI Shipping Credit and Investment MUL Maruti Udyog Limited Corporation of India MUV Manufactures Unit Value SDF Sugar Development Fund MW Megawatt SDP State Domestic Product NABARD National Bank for Rural Development SDR Special Drawing Rights NCAER National Council of Applied Economic SDS Special Deposit Scheme Research SEB State Electricity Board NEP New Economic Policy SEBI Security and Exchange Board of India NFA Net Financial Assets SEEPZ Santacruz Electronics Export Processing NGO Non-Governmental Organization Zone NHAI National Highways Authority of India SFC State Financial Corporations NHB National Housing Bank SICA Sick Industrial Companies Act NPK Nitrogen, Phosphate & Potash SIDBI Small Industries Development Bank of NPV Net Present Value India NR(NR)D Non-Resident (Non-Repatriable) Deposit SIL Special Import License Scheme SITC Standard International Trade NRER(A) Non-Resident External Rupee Account Classification NRF National Renewal Fund SLR Statutory Liquidity Requirements NRI Non-Resident Indians SMP Skim Milk Powder NRY Nehru Rozgar Yojana SPE State Public Enterprise NSE National Stock Exchange SSA Sub-Saharan Africa NSS National Sample Survey SSI Small Scale Industry NSSO National Sample Survey Organization ST Scheduled Tribes NTB Non-Tariff Barriers STCI Securities Trading Corporation of India NTPC National Thermal Power Corporation TEU Twenty-feet Equivalent Unit O&M Overhaul and Maintenance TFC Tenth Finance Commission OECD Organization for Economic Cooperation TFP Total Factor Productivity and Development TLC Total Literacy Campaign OTCEI Over-the-Counter Exchange TOT Terms of Trade P and K Phosphate and Potash TRAI Telecom Regulatory Authority of India PD Primary Dealers TRIPS Traded Intellectual Property Rights PDS Public Distribution System TRYSEM Training of Rural Youth for Self- PE/ PSE Public Enterprise/ Public Sector Employment Enterprise UNCITRAL United Nations Commission on PLF Plant Load Factor International Trade Law POL Petroleum, Oil and Lubricants UNESCO United Nations Educational, Scientific PPP Purchasing Power Parity and Cultural Organization PRI Panchayati Raj Institutions UP Uttar Pradesh PSU Public Sector Units UST United States Treasury PWD Public Works Department UT Union Territory QR Quantitative Restrictions UTI Unit Trust of India R&M Renovation and Modernization VAT Value Added Tax RBI Reserve Bank of India VSAT Very Small Aperture Terminal RBNZ Reserve Bank of New Zealand WPI Wholesale Price Index RE Revised Estimates WTO World Tourism Organization REB Regional Electricity Board WUA Water Users' Association REER Real Effective Exchange Rate  - xi - CURRENCY Rs/ US$ Currency Official Unified Market& Prior to June 1966 4.76 June 6, 1966 to mid-December 1971 7.50 Mid-December 1971 to end-June 1972 7.28 1971-72 7.44 1972-73 7.71 1973-74 7.79 1974-75 7.98 1975-76 8.65 1976-77 8.94 1977-78 8.56 1978-79 8.21 1979-80 8.08 1980-81 7.89 1981-82 8.93 1982-83 9.63 1983-84 10.31 1984-85 11.89 1985-86 12.24 1986-87 12.79 1987-88 12.97 1988-89 14.48 1989-90 16.66 1990-91 17.95 1991-92 24.52 1992-93 26.41 30.65 1993-94 31.36 1994-95 31.40 1995-96 33.46 April 1996 34.24 May 1996 34.99 June 1996 34.99 July 1996 35.52 Aug 1996 35.69 Note: The Indian fiscal year runs from April I through March 31. Source: IMF, International Finance Statistics (IFS), line "rf'"; Reserve Bank of India. a A dual exchange rate system was created in March 1992, with a free market for about 60 percent of foreign exchange transactions. The exchange rate was reunified at the beginning of March 1993 at the free market rate.  - xii - ECONOMIC DEVELOPMENT DATA GNP Per Capita (US$, 1994-95): 330 a Gross Domestic Product (1994-95) Annual Growth Rate (% p.a., constant prices) % of 70-71- 75-76- 80-81- 85-86- 92-93- 93-94- USS Bln GDP 75-76 80-81 85-86 90-91 93-94 94-95 GDP at Factor Cost 272.0 90.3 3.4 4.2 5.4 5.9 5.0 6.3 GDP at Market Prices 301.2 100.0 3.3 4.2 5.6 6.2 3.9 6.3 Gross Domestic Investment 69.7 23.2 5.3 3.7 5.7 9.5 -5.8 19.8 Gross National Saving 67.0 22.3 4.4 2.6 3.5 8.7 -1.1 17.2 Current Account Balance -2.7 -0.9 -- -- -- -- -- -- Output, Employment and Productivity (1990-91) Value Added Labor Force b V. A. per Worker US$ Bln. % of Tot Mill. % of Tot. US$ % of Avg. Agriculture 82.5 31.0 186.2 66.8 443 46.4 Industry 78.0 29.3 35.5 12.7 2195 230.0 Services 105.7 39.7 57.2 20.5 1849 193.7 Total/ Average 266.2 100.0 278.9 100.0 954 100.0 Government Finance General Govermnent c Central Govemment Rs. Bin % of GDP R.Bln. % of GDP 1994-95 1994-95 90-91-94-95 1994-95 1994-95 90-91-94-95 Revenue Receipts 1809.0 19.1 19.5 910.8 9.6 10.1 Revenue Expenditures 2219.0 23.5 23.5 1221.1 12.9 13.3 Revenue Surplus/ Deficit (-) -409.9 -4.3 -4.0 -310.3 -3.3 -3.2 Capital Expenditures d 337.9 3.6 4.3 266.8 2.8 3.5 Extemal Assistance (net) e 51.5 0.5 0.7 51.5 0.5 0.7 Money, Credit, and Prices 89-90 90-91 91-92 92-93 93-94 94-95 95-96p (Rs. billion outstanding, end of period) Money and Quasi Money 2309.5 2658.3 3170.5 3668.3 4344.1 5308.0 6005.0 Bank Credit to Govemment (net) 1171.5 1401.9 1582.6 1762.4 2039.2 2224.2 2626.7 Bank Credit to Commercial Sector 1517.0 1717.7 1879.9 2201.4 2377.7 2896.6 3386.4 (percentage or index numbers) Money and Quasi Money as % of GDP 50.6 49.6 51.4 52.0 54.2 56.1 54.7 Wholesale Price Index (1981-82 = 100) 165.7 182.7 207.8 228.7 247.8 274.7 295.8 Annual Percentage Changes in: Wholesale Price Index 7.4 10.3 13.7 10.1 8.4 10.9 7.7 BankCredittoGovemment(net) 20.3 19.7 12.9 11.4 15.7 9.1 18.1 Bank Creditto Commercial Sector 14.4 13.2 9.4 17.1 8.0 21.8 16.9 a. The per capita GNP estimate is at market prices, using World Bank Atlas methodology. Other conversions to dollars in this table are at the prevailing average exchange rate for the period covered. b. Total Labor Force from 1991 Census. Excludes data for Assam and Jammu & Kashmir. c. Transfers between Centre and States have been netted out. d. All loans and advances to third parties have been-netted out. e. As recorded in the govemment budget.  - xiii - Balance of Payments (USS Millions) 1992-93 1993-94 1994-95p Merchandise Exports (Average 1990-91-1994-95) Exports of Goods & NFS 23,585 28,925 34,141 Merchandise, fob 18,869 22,700 26,857 USS Mill % of Tot. Imports of Goods & NFS 26,825 29,433 39,450 Merchandise, cif 23,237 23,985 31,672 Tea 415 2.0 of which Crude Petroleum 3,711 3,468 3,428 Iron Ore 480 2.3 of which Petroleum Products 2,208 2,285 2,500 Chemicals 1,679 8.1 Trade Balance -4,368 -1,285 -4,815 Leather & Leather products 1,382 6.7 Non Factor Service (net) 1,128 777 -494 Textiles 2,483 12.0 Garments 2,542 12.3 Resource Balance -3,240 -508 -5,309 Gems and Jewelry 3,449 16.7 Engineering Goods 2,674 13.0 Net factor Incomea -3,422 -4,002 -3,905 Others 5,536 26.8 Net Transfersb 2,773 3,825 6,200 Total f 20,641 100.0 Balance on Current Account -3,889 -685 -3,014 External Debt, March 31, 1995 Foreign Investment 587 4,110 4,895 US$ Mill. Official Grants and Aid 363 370 390 Public & Publicly Guaranteed 87,880 Net Medium & Long Term Capital 1,636 1,716 278 Private Non-Guaranteed 1,709 Gross Disbursements 4,586 5,884 5,091 Total (Including IMF and Short Ter 98,990 Principal Repayments 2,949 4,169 4,814 Debt Service Ratio for 1994-95 Other Capital Flowsc -961 2,086 3,462 Non-Resident Deposits 2,001 940 847 % curr receipts Net Transactions with IMF 1,290 190 -1,174 Public & Publicly Guaranteed 19.6 Private Non-Guaranteed 1.2 Overall Balance -263 8,537 6,858 Total (Including IMF and Short Ter 25.3 Change in Net Reserves 263 -8,537 -6,858 IBRD/ IDA Lending, March 31, 1995 (USS Mill) Gross Reserves (end of year)d 6,749 15,476 21,160 IBRD IDA Rate of Exchange Outstanding and Disbursed 11,120 17,666 Undisbursed 4,227 4,663 End-March 1996e US$ 1.00 = Rs. 34.45 Outstanding incl. Undisb. 15,347 22,329 -- Not available. a. Figures given cover all investment income (net). Major payments are interest on foreign loans and charges paid to IMF, and major receipts is interest eamed on foreign assets. b. Figures given include workers' remittances but exclude official grant assistance which is included within official loans and grants, and non-resident deposits which are shown separately. c. Includes short-term net capital inflow, changes in reserve valuation and other items. d. Excluding gold. e. The exchange rate was reunified at the market rate in March 1993. f Total exports (commerce); net of crude petroleum exports.   - xv - India Meost Sa:mosI ewc arty NW Unit of estmae Sowh *La m_ indicator measure 1970-75 1980-t5 1989-94 Asia jacerme g, Resources and Exoenditures HUMAN RESOURCES Popubation (zre-1994) thousands 613,459 765,147 913,600 1.220.22 5 3.182.221 1.096,8 I Age dependency atio ratio 0.77 0.72 0.66 0.71 0.66 0.63 Urban % of pop. 21.3 24.3 26.5 26.0 28.3 55.9 Population gmwth rae arnnual % 2.3 20 1.7 I.S 1.7 13 Urban 3.7 3.0 2.7 3.1 3.2 2.7 Labor force thousands 260.515 329.608 394,330 528.0S 1.590.533 48e.647 Agncultuze % oflaborfvrce 70 67 64 63 67 36 Industry 13 14 16 16 14 26 Fenile 31 32 32 32 39 40 Labor participation razs4 Toul % of pop. 42 43 43 43 50 45 FeaIe C 13 14 14 29 41 36 NATURAL RESOURCES Area thou. sq. km 3,27.59 3=.7.59 3,27.59 5.133.49 40391.42 40.594.43 Density pop. per sq. km 186.60 232.74 273.21 233.41 77.44 26.66 Agncultralland %of land uaa 60.83 60.86 60.89 59.11 52.42 41.05 Change i agncultural Iand Annual % 0.47 -0.07 -0.05 m02 0.16 -138 Agncutul land underi iganon % 18.65 23.09 25.96 29.63 17.84 11.40 Forests and woodland thou. sq. kn .. 551.19 517.29 65S32 7,632.00 5.969.25 Deforestaton (net) % change. 198090 .. 0.63 - INCOME Household income Shimoftop 20%ofhouseholds %ofincome 49 41 43 -- Share of bonom 40% of househods 16 20 21 _ _ _ Shre of bottom 20% of houbolds ' 6 8 8 _ E(PENDmURE Food %ofGDP 43.6 35.3 .. Stapeas 20.6 124 .. Mau fish. milk. che. ew 6.5 7.4 .. Calw import thou. meaic tome 7.669 205 694 6.211 36.922 68.936 Food aid in cereals 1.582 304 276 1.624 8.516 5,771 Foodproductionpercapita 197- 100 94 104 115 113 115 102 Fertilizer consump'on kgra 19.3 47.0 67.5 69.7 58.5 46.3 Shim of asiculure in GDP % of GDP 36.6 29.5 26.9 26.6 27.6 14.0 Housing %ofGDP 4.4 7.1 .. ..- Average household size penons per household 5.2 5.6 . Urban ' 4.8 5.5 Fixed investmcnt:housing %ofGDP 2.3 2.8 - Fud and poer %ofGDP 2.4 2.3 Enargyconsumptionpercapats kgofoilequiv. 124 170 243 219 373 1,602 Households with clecricdzy Urban % of households _ - - - _ - Rwal _ _ Trnsportandcomm ia ioe %ofGDP 4.7 5.1 .. Fixed investmenc tansport equipment 1.4 2.3 Total road length thou. km 1.375 146 2.962 . VfVESTMENT IN IIUMAN CAPITAL HEath Populaton per physician persons 4.900 2.522 .. .. .. 3.064 PopulaIonpernUrSe 3.710 1.701 -.. Populauon per hospital bed 1.700 1.300 1371 1.675 1.034 592 Oral rchydyruion therapy (under-S) % of ases .. .. 37 37 38 Education Gross cnrollmcnt ratios Secondary % of shooi age pop. 26 37 49 45 48 63 Female 16 26 38 35 42 62 Pupil-tacherrctio: primary pupils per achr 42 58 63 61 39 Pupil-tcacher rado: secondary 21 21 26 26 20 Pupils reaching grade4 % of ohort 51 58 ..- Repeater rate: primary % of total enroUl 17 - 1 . - mliteracy % of pop. (age IS.) 66 56 4S 51 35 _ Fernale %of fen. (age I5s) .. 71 62 64 46 _ Newsta,er circulation ver thou., v. 15 26 31 26 236 World Bank Intnational Economir Department. April 1996  - xvi - India Maet Sams rqiea;usce gre' Amap Latst suugiwe er rsecent . iuitier Uvu of eurmere Sout TIw- income Indicator measUre 1970-75 198045 1.989-94 Aris ihoeme rr Priority Poverty Indicators POVERTY Upper povery line local curr. .. .. .. Headcot index 9 of pop. .. .. Lower povesy line local curr. .. .. Headcount index % of pop. .. .. ._ GNP percapiu USS 180 280 310 320 390 1,670 SHORT TERM INCOME INDICATORS Unskilled urban was local curr. . Unskilled rurl wag_s - Runal ems of ade .. 84 94 Consuaer price index 1987-100 45. 85 189 _ _ Lower income Food& - 27 __ Urban .. 83 176 Rural 17_ SOCIAL INDICATORS Public expendiure on basic soci sevices * of GDP .. .. .. Gross enrollment ios Primary % school age pop. 79 96 102 98 105 104 Male ' 94 110 113 110 112 105 Female 62 S0 91 87 98 101 Morality Infant monality per thou. live births 132 IdS 70 73 58 36 UnderS morality . - 97 106 101 47 Imuunizaona Measles % age goup _ SS.8 84.2 86.2 77.4 DFr ' 41.0 90.2 88.6 89.1- 82.0 Ghild malnutrton (under-5) ' 63.0 61,5 38.2 Life expecancy Toual uS 50 S 5 62 61 63 67 Female advantage -1.9 -0.4 1.3 1.2 2.4 6.4 Total ferdlity miue births per n 5.6 4.8 3.3 3.6 33 2.7 Matrnalm ruolity rt per 100,000 live births 460 437 - Supplementary Poverty Indicators Expenditu on social security % of toal gov't exp. . Social security cverage % econ. active pop. Access tosafewawer. tota % ofpop. 31.0 563 _ Urban ' 80.0 76.0 Rural 18.0 50.0 Access to health care ' 75.0 Population growth rate GNP per capita growth rate Development diamondb (aver6ge aus1 percent) 5 (avee annual. percent) epecnY 4 -S 2 - 707 GNP O -~ C~ -1 1 ~ l I rp g__Gross per capita enrollMclnt -2 I10 1970-75 1980-85 1989-94 1970-75 1980-S5 19S9-94 Acces to safe watr M Indiat India - Low.income - Low-conme a. See htechnicul notes, p3S7. b. The development diamond, based on four key indicators, shows the averagc level of development in the country compared with iu income group. See the intoduction  - xvii - EXECUTIVE SUMMARY The Ministry's of Finance's 1995-96 Economic Survey and its July 1996 update analyze candidly and insightfully the accomplishments of five years of stabilization and reform. The new government's Common Minimum Program of June 1996 identifies the key challenges ahead: reducing the country's chronically high fiscal deficits, further liberalizing the economy, agriculture in particular, meeting the infrastructure challenge, and ensuring social justice. These documents are the point of departure of this Country Economic Memorandum (CEM). Part I sums up the achievements and shortcomings of five years of stabilization and reform. Part II outlines the challenges ahead. A Summing Up India has Fundamentally Altered Its Development Strategy India's pre-1991 planned approach to development helped the country escape from the massive illiteracy, recurrent famines, fertility rates of about 7 children per woman, and secular stagnation prevailing before Independence. However, it also led to an over-extended public sector, responsible for half of the country's gross investment, and created severe financial imbalances which are yet to be corrected. It isolated the country from the rest of the world with the result that from 2 percent in the 1950s, India's share of world trade had declined to less than half of one percent in the late 1980s. It forced Indian consumers to pay higher prices for goods of lower quality and deprived the country of the benefits of foreign direct investment and modern technology. It discouraged production for exports, created recurrent shortages of foreign exchange, and made the balance of payments extremely vulnerable to external circumstances. Most important of all, it held back the country's growth and thus the pace at which poverty could have been reduced. In June 1991, in the midst of severe fiscal and external imbalances, which had generated double-digit inflation and put the country on the verge of defaulting on its external debt obligations, a new government undertook the major task of stabilizing and liberalizing the economy. Over the past five years, reform of the investment, exchange-rate and trade regimes, of the financial sector, and of the tax system have ended four decades of planning and have initiated a quiet economic revolution. With these reforms, India has joined the growing group of countries which, starting in the 1970s and 1980s, have gradually but persistently taken measures to deregulate their domestic markets, increase their integration with the global economy, and reduce the role of government. India did not have the inflation, external debt, and social inequities so severe in Latin America--and was thus able to stabilize the economy more rapidly and at a lower social cost. Unlike former centrally planned economies in Eastern Europe and elsewhere, and while  - xviii - extremely regulated, India already had an ubiquitous private sector, all the institutions of a free market economy, and a relatively well-developed financial sector. India was thus able to avoid the costly industrial and financial closures and restructuring, so frequent and so painful in most of the former socialist economies of Eastern Europe and Central Asia, and which have considerably delayed the supply response to reforms. On the other hand, the fact that India's macroeconomic problems were considerably less traumatic than in Latin America also meant that they were less palpable. Consequently, it has been much harder to reach political consensus on the need to reduce fiscal imbalances. India has adjusted its fiscal accounts much less than Latin American, East Asian and Western European countries--and fiscal imbalances remain the most important threat to India's long term growth. Similarly, India's pre-1991 trade regime yielded levels of protection considerably higher than Latin American and East Asian countries'. Even after five rounds of significant trade reforms, India's tariff and non-tariff barriers still remain among the world's highest. Likewise, before 1991, India's private sector probably was the most controlled in the non-socialist world. Thus, and in spite of five years of liberalization measures, regulation still remains a problem in important segments of the economy--the financial sector, agriculture and agro-industry in particular. In addition, in the financial sector, the public sector continues to be the major shareholder of India's largest banks, insurance companies, and contractual savings institutions-- raising questions on how truly autonomous these financial institutions can be. Finally, the development of India's human resources has been slow in comparison with countries in East Asia or Eastern Europe. Highlights of Five Years of Stabilization The economic recovery has been unexpectedly rapid and robust. Initially, growth declined sharply in response to the devaluation and contractionary fiscal and monetary policies adopted in June 1991 to address the foreign exchange crisis India was facing then. From over 5 percent in 1990-91, GDP growth declined to less than one percent in 1991-92. Then, helped by an unprecedented sequence of good monsoons, a relaxation in fiscal policies, and a strong supply-response to the reforms, growth accelerated to 5 percent in 1992-94, 6 percent in 1994-95 and 7 percent in 1995-96. With growth rates exceeding 10 percent in the last two years, the industrial recovery has been particularly strong. Because it is being driven by exports and private investment, and is being accompanied by an increase in domestic savings, the recovery has thus far not put pressure on inflation or the external accounts. However, unless pressing stabilization and reform issues are expeditiously addressed, the country may not be able to sustain this performance. Inflation has declined from the high 14-15 percent levels prevailing in 1991-92. This was achieved by generally strict monetary policies which were maintained in spite of persistently high public sector deficits, and liberalization of interest rates. Unexpectedly large capital inflows starting in late 1993 complicated monetary management in 1993-95 and caused money supply temporarily to increase at rates exceeding 20 percent and inflation to rise above 10 percent (after it had declined to below 8 percent). By early 1994, concern with the repercussions of higher  - xix - inflation and loss of real exchange-rate competitiveness led the authorities to implement a pragmatic mixture of measures to slow down certain categories of capital inflows--particularly those that are easily reversible, or imply a high debt service burden. Helped by increases in US interest rates and adverse developments in emerging markets in the wake of the Mexican crisis, these measures worked well and allowed the RBI to tighten its monetary stance and inflation to decline to below 5 percent in 1996. However, in the absence of a sufficiently strong fiscal correction, this has come at the cost of high real interest rates which are a threat to the sustainability of the recovery and to the soundness of the banking system. In addition, the current rate may not be indicative of the true underlying inflation since, recent increases notwithstanding, the administered prices of some petroleum products and some food items need adjustment. The external accounts, both current and capital, have improved significantly. In response to a sharp depreciation of the real exchange rate and reduction of import tariffs, and therefore of the anti-export bias implicit in the previous trade regime, exports grew at rates in excess of 20 percent for the past three years, and prospects for 1996-97 are equally encouraging. Consequently, and in spite of the rapid growth of imports (mostly of intermediates and capital goods) of the last two years resulting from the industrial recovery, the current account deficit has remained below 2 percent of GDP--an amount well within prudential levels. Improvements in the capital account have been equally significant. At US$2 billion in 1995-96, while well below China's US$31 billion, foreign direct investment is 15 times higher than it was before the economy was liberalized and portfolio investment has stabilized at around US$2-3 billion--that is 10 percent of world portfolio investment in emerging markets, a share in line with that of China and Indonesia. These developments in the current and capital accounts led foreign exchange reserves to increase to US$17 billion, that is 5 months of imports and the debt service ratio to decline--from 30 percent of current account receipts in 1990-91 to 24 percent in 1995-96. However, meaningfulfiscal adjustment has yet to take place. With the exception of the first year of the stabilization and reform program, when its deficit was reduced from 8.3 percent of GDP in 1990-91 (with a primary deficit of 4.3 percent of GDP) to 6 percent in 1991-92, the Central Government has persistently relaxed its fiscal deficit targets. In 1995-96, at 5.9 percent of GDP (with a primary deficit of 1.1 percent of GDP), the fiscal deficit was one half percent of GDP above the 1995-96 target--and well over the 3 percent of GDP the Government set as a target at the beginning of the stabilization and reform program. There are several reasons. First, several of the structural reforms have had a relatively high fiscal cost. For example, the reduction of import tariffs and the rationalization of excises (to make the excise system more closely resemble a value added tax) came at a cost, which in some years exceeded one percent of GDP in foregone revenues. The liberalization of financial markets meant higher interest costs on Central Government debt--interest payments on the Central Government debt are close to 1 percent of GDP higher than they were five years ago. Second, political and social considerations led the Government to retain some important subsidies such as the fertilizer subsidy. While this may have reduced the social cost of the  - xx - stabilization and reform program for the poor, it has cost the budget over half of a percent of GDP per year. Third, progress in reforming public enterprises has been much slower than expected. Contrary to the experience of other countries, India's fiscal adjustment did not benefit from the proceeds of privatization nor from the dividends that better managed public enterprises could have generated. The Central Government is the majority shareholder, and in some cases the sole shareholder, of 240 enterprises, about 27 large banks, and two large insurance companies. While some of these enterprises are highly profitable, most generate profits and dividends insufficient to compensate the Government for the cost of funds invested in them. Over the past five years, losses of loss-making enterprises have not declined, while profits of profit making enterprises have increased only marginally. Fourth, fiscal adjustment by the Central Government has been limited by the absence of corresponding adjustment by India's 25 states. One-fourth (about 4 percent of GDP excluding states' share of taxes collected by the Central Government) of Central Government spending is in the form of grants and loans to the states which the Central Government has found difficult to curtail. As a result, over the last five years, the states' consolidated fiscal deficit has not declined--it has hovered around 3 percent of GDP. As discussed in last year's World Bank Economic Memorandum on India, there is evidence that the current system of transfers discourages fiscal discipline because: (a) "grants-in-aid" to the states at least partly are meant to cover their current deficits and thus create incentives for increasing them; (b) transfers in the form of loans and grants authorized by the Planning Commission (set up soon after Independence with a mandate rooted in India's pursuit of a centrally planned development strategy, it has become a de-facto development bank without the prudential financial standards that typically guide such banks) are not used for their intended productive purposes and thus increase the states' debt without increasing their capacity to service it; and (c) periodic Central Government loan forgiveness and refinancing, without conditionality, have created an expectation of future debt relief. In addition, the deterioration in the states' finances is being compounded by a decline in the quality of their spending. There is growing evidence of a crisis of expenditure composition at the state level whereby resources for the provision of operations and maintenance of key infrastructure (roads, irrigation, primary education and health facilities) for which the states have responsibility are being cut to sustain less productive expenditure and subsidy programs. Highlights of Five Years of Structural Reforms The liberalization of the investment regime is nearly complete. Five years ago, investment in the most important areas of the economy was a public sector monopoly and foreign investment was discouraged--at US$150 million in the early 1990s, foreign direct investment in 900 million India was as high as in 17 million neighboring Sri Lanka. Currently, there are few areas where private investors, domestic or foreign, cannot invest and India's foreign investment regime is as investor friendly as that of the East Asian countries. In telecommunications, power and mining, it is significantly more open than that of its East Asian neighbors. With the recent  - xxi - liberalization of pharmaceuticals and, in part, coal, the main areas still reserved for the public sector are insurance and railways. This progress notwithstanding, the remaining licensing restrictions mainly to protect small scale industry, including agro-industry, have considerable negative repercussions. For example, continuing regulation of the sugar industry is extremely costly while the reservation of about 800 products for small scale enterprises discourages economies of scale and adoption of modem technology. In addition, in many instances, investing in India remains difficult because of mostly state-level regulations and administrative burdens that are far from transparent and differ from state to state--and affect domestic and foreign investors alike. The trade and foreign exchange regimes have been substantially liberalized, but protection levels are still high. In June 1991, India had the most restrictive trade regime of the non-socialist world. Virtually all goods could only be imported if authorized by the Government and, with maximum tariffs over 300 percent and average (import-weighted) tariffs of 87 percent, India had the world's highest tariffs. Several rounds of trade reforms have lifted all licensing restrictions on imports of intermediate and capital goods, liberalized marginally imports of consumer goods, and reduced maximum tariffs for non-consumer goods to 40 percent and the import weighted average tariff to 22.7 percent. Tariffs for imports of capital goods have been reduced more rapidly than for other items. In parallel, the exchange-rate regime has been liberalized, and full convertibility has been established for current account transactions. This progress notwithstanding, India will need to liberalize its trade regime even further if the country is to reach the openness of its East Asian and Latin American competitors where import weighted tariffs are in the 10-15 percent range. A skillful and significant liberalization of the financial sector-but the public sector remains dominant. With a financial savings rate of 9 percent of GDP in 1990-91 (11 percent of GDP at present), India's pre-1991 policies had been successful at developing a solid deposit base, and a diversified stock of financial instruments. However, until very recently, the financial sector had been dominated by public banks which had limited discretion in allocating their lending (in 1991 as much as 63.5 percent of increases in bank deposits had to be held in cash reserve requirements and government securities, and 40 percent of the remaining had to be allocated to priority sectors designated by government) and publicly-owned insurance companies still have to hold more than half of their portfolio in government-designated securities. Prudential regulations had no real role to play in the deployment of capital and in any case were inadequate making it difficult to assess the true quality of bank portfolios or bank profits. Interest rates and financial instruments were tightly regulated, and competition was limited by restrictions on entry of new banks, insurance companies, or mutual funds. Pricing and terms of new equity issues were regulated. Because of persistently large public sector borrowing requirements and weak public banks balance sheets, the government has chosen a phased approach to liberalizing the financial sector--but this approach has been excessively gradual in the case of privatization of the public banks and deregulation of insurance companies and contractual savings institutions. Much of the reform effort has focused on establishing the institutional base required for deregulated financial  - xxii - markets to operate efficiently, and in deregulating the markets themselves. In particular, prudential regulations that meet international standards have been introduced, and to improve its capacity to enforce the new prudential guidelines, the RBI created a Board of Financial Supervision which began functioning in December 1994. Several steps have been taken to develop markets in government securities, including the creation by RBI of a dealer network to operate in and provide liquidity to government security markets, followed by the approval of the first six private primary dealers in 1996. In parallel, measures have been taken to develop the Securities and Exchange Board of India's (SEBI) capacity to provide oversight regulation in India's stock markets and to increase the transparency of stock market transactions. In particular, legislation has been enacted to improve title transfers and a code for takeovers has been formulated. A new modern electronic securities exchange system, the National Stock Exchange (NSE), which allows scripless transactions, began operating in 1995. In November 1995, the government established an insurance regulatory body, to prepare the basis for eliminating the public monopoly in this sector--although a decision on this has yet to be taken. Interest rates are now market determined for most transactions and the government is committed to eliminate by 1997 its automatic access to RBI credit. However, while progress has been achieved in relaxing controls, reducing government's pre-emption of financial savings, and reestablishing the soundness of the financial system, much remains to be done. In particular, forced holdings of government debt by banks, while reduced, remain at a high 37 percent of deposits and 40 percent of banks' loan portfolios still must be allocated to designated "priority sector lending". While barriers against the entry of private banks (domestic and foreign) have been relaxed, public sector banks continue to hold around 90 percent of the sector's assets and little progress has been achieved in reducing government equity holdings in the public banks or in improving their autonomy in key areas such as staffing and pay. As a result, financial intermediation costs remain excessive and the increased autonomy of financial sector institutions also remains in doubt. The tax regime has been simplified and strengthened. Prior to 1991, India's tax base was excessively dependent on custom revenues, and was characterized by taxes with a multiplicity of high rates falling on a narrow base. Several steps have been taken to address this problem. In the 1994-95 Budget, taxes on corporate income were unified at 46 percent for widely held companies and 55 percent for branches of foreign banks. A major reform of excises was implemented to make it more closely resemble a value-added tax and address its major problems. Meanwhile, the Government extended the coverage of MODVAT (a modified value- added tax) to include manufacturing sectors thus far excluded, and, for the first time, some services. Of particular importance also were the decisions to: (a) shift most excise rates from specific to ad-valorem to increase buoyancy; (b) reduce the number of rates; and (c) simplify the system by relying on invoices for value determination. These reforms considerably simplified and modernized India's tax system and made it possible for the Central Government to focus its efforts on improving tax administration. The 1995-96 Budget further reduced peak excises and continued the emphasis on simplification, strengthened compliance, lower rates, and greater  - xxiii - buoyancy. Further and significant tax reforms were introduced in the 1996-97 budget including the full incorporation of the textile sector into the VAT. The effects of five years of stabilization and reform on the poor. A key objective of India's liberalization program has been employment creation and poverty alleviation through accelerated growth. Many of the measures introduced over the past five years have brought India's development policies closer to those of East Asian countries such as Indonesia and China which have been successful in reducing the incidence of poverty in a relatively short period of time. In particular, the sharp devaluation of the rupee and the decline in the protection of manufacturing have improved the agricultural terms of trade. Also, the reduction in the anti- export bias implicit in the pre-1991 trade regime has led to a rapid expansion of labor-intensive exports--which in other countries have been a key factor in employment generation and poverty reduction. However, at the same time, there has been considerable concern on the effects that some of the stabilization and structural reform measures introduced over the past five years might have had on the living standards of the poor. In particular, there have been significant increases in the prices of key commodities such as fertilizer, rice, sugar, cotton, and gasoline. Further, increases in inflation due to rapid monetary growth in 1993-94 and 1994-95 (because of the monetization of capital inflows), and increases in the prices of key agricultural commodities (the result of higher issue prices and the delayed effect of the sharp devaluation) accentuated fears that the program of stabilization and reform might be putting an excessively high burden on the poor. The 1993-94 National Sample Survey (NSS) released in July 1996 indicates that the incidence of poverty has declined. The publication of this survey is too recent, however, for a careful analysis of its findings to be included in this CEM. It is also not possible to provide definitive answers about how poverty has evolved over the past two years since no NSS data are available as yet. For the purposes of this report, and as a very first approximation, case studies were carried out by Indian economists and social scientists, between January and March 1996, in Maharashtra, Tamil Nadu, Punjab, and Uttar Pradesh. The results of this exercise suggest that poverty is unlikely to have increased in the recent past. In addition, variables that are good predictors of poverty (such as wages for unskilled agricultural labor, agricultural production, overall growth and inflation) have evolved in a direction that suggests that the incidence of poverty might in fact have declined. This view is reinforced by the case studies results which document no noticeable decline in food consumption. However, in the absence of firm data for the last two years these results cannot be generalized. More interestingly perhaps, a strong result that also emerges from the case studies is that the existing welfare and safety net programs seem to be barely noticed by those who were being interviewed. In spite of the significant resources that the country allocates to such programs, there is little evidence that they have a palpable effect on the living standards of the poor. This may be because the newer programs (i.e., RPDS, EAS schemes, benefits for widows) have not yet reached intended beneficiaries on any significant scale. This also can be, however, an indication that the older programs have failed to reach their targeted population. Again in this  - xxiv - case, only with the household survey results will it be possible to clarify the underlying reasons and-reach definitive conclusions regarding the impact of the reforms on the poor and the cost effectiveness of the various anti-poverty programs. Highlights of the 1996-97 Budget On July 22, the Minister of Finance presented to Parliament the 1996-97 budget, the first of the 13-parties United Front (UF) government. The budget takes several steps to implement the Common Minimum Program (CMP) and makes it clear that this government intends to continue the reforms started in 1991. On stabilization, the budget proposes a welcome fiscal correction of 0.9 percent of GDP. However, the measures envisaged in the budget may not be sufficient to attain this target. The 0.9 percentage point reduction is to be achieved through a 0.7 percentage points of GDP increase in revenue, and a 0.2 percentage point reduction in expenditure. Some of the assumptions underlying both the revenue and the expenditure forecasts may be overoptimistic. On the revenue side, it is assumed that sales of government equity in public enterprises will reach US$1.5 billion and that tax revenues will increase by 20 percent on account of a 14 percent increase in nominal GDP (half real growth and half inflation) and of several tax measures introduced in the budget. On the expenditure side, a 9 percent increase in provision for wages is deemed to be sufficient to accommodate wage increases stemming from the Pay Commission recommendations. Finally, defense expenditure has continued to decline relative to GDP (from 2.9 percent of GDP five years ago to 2.2 percent of GDP at present) and there may be some pressure to restore it at higher levels. At the same time, new claims have been put on the budget to increase the fertilizer subsidy (0.2 percent of GDP) and support for public enterprises (0.1 percent of GDP), expand an already existing rural infrastructure fund, strengthen the capital base of the national agricultural bank (0.1 percent of GDP), and, for a relatively small amount, recapitalize several small public banks. The budget also announces a cautious, but clear commitment to permit greater decentralization within India's federal structure by: (a) gradually transferring most centrally sponsored schemes to the control of the states; (b) proposing constitutional change to include all central taxes in the federal transfer division pool as recommended by the Tenth Finance Commission; (c) designing a Ninth Five-Year Plan which will put emphasis on decentralization of responsibility; and (d) convening a conference of Chief Ministers on center-states relations and federalism. In addition, the budget also announces the government intention to target the Public Distribution System and, potentially, other social safety nets programs, to families below the poverty line. Finally, the Minister of Finance proposed to appoint a high level Expenditure Management and Reforms Commission to submit within four months recommendations on how to improve public expenditure control and management, and proposed to place before Parliament a discussion paper on subsidies and their appropriate targeting. These are welcome initiatives that will permit a public discussion of the structural reasons for India's chronically high fiscal deficits.  - xxv - On the structuralfront, except for taxation, and in spite of progress in modestly further liberalizing the trade and foreign investment regimes, the budget refrains from bold structural reform initiatives at this time while stimulating the public debate on these issues. In particular, several much discussed and awaited reforms have not taken place: (a) the end of the public sector monopoly on insurance has been postponed; (b) imports of consumer goods have not been liberalized; and (c) deregulation of agriculture has not started. Reform of the tax regime has continued. Several tax measures have been taken to continue the broadening the tax base, reduce rates and improve tax administration. This has been particularly important in the case of excises and corporate taxation. Corporate taxation has been reduced from 46 percent to 43 percent, and a new Minimum Alternate Tax has been introduced to bring into the tax net corporations that avoid paying taxes on corporate income or benefit from excessive exemptions. The long-term capital gains tax for domestic companies has been reduced to 20 percent in line with that for foreign companies. The foreign investment regime has been further liberalized by allowing portfolio investors to invest in non-listed securities, and by raising the limit of the maximum of equity they can hold in any given company. Regarding the trade regime, import tariffs have been reduced on a number of items with the result that the maximum tariff for non-consumer goods is now 40 percent. On social issues, the new government has used its first budget to signal strong commitment to poverty reduction and rural development. Besides the support to the national agricultural bank and rural infrastructure, the budget introduced several initiatives to improve the living standards of the rural poor. In particular, it provides Rs 24 billion (0.2 percent of GDP) for state-level social programs aimed at increasing the provision of safe drinking water, primary education, primary health, housing, mid-day meals for primary school children, rural roads and a strengthened public distribution system covering all below the poverty line. It also reiterates commitment to achieving 100 percent coverage of provision of safe drinking water, universalisation of primary education and basic health care, and extension of the mid-day meal program. A new initiative to mobilize additional capitalfor the development of infrastructure. The budget also announced that an Infrastructure Development Finance Company (IDFC) will be established, involving a budgetary outlay of Rs 5 billion for equity. This is to be matched by an equal contribution from the Reserve Bank of India. The IDFC is intended to play the role of direct lender, refinance institution as well as the provider of financial guarantees, that will induce private financiers to advance "long-term funds at the lowest possible market rates". The Challenges Ahead The stabilization and reform measures introduced over the past five years have considerably improved India's growth prospects. The growth performance of the last two years and preliminary indications for 1996-97 confirm this view and may suggest that the reforms have created the preconditions for India to grow at a stable 6-7 percent annual growth. This inevitably  - xxvi - raises the question of whether India will be able to grow at high, East Asian rates. The answer is that strong corrective measures are necessary for this to happen. Not only is the country facing serious fiscal imbalances that the 1996-97 budget corrects only partially, but there also remains a challenging agenda of structural reforms that needs urgently to be addressed even to sustain the current growth rate, let alone exceed it. Addressing Fiscal Constraints India's persistently large fiscal imbalances have led to an increasing volume of public debt, which has been accompanied by a rising trend in real interest rates in recent years. At present, the marginal real interest rate that the Government pays on its domestic debt is close to the economy's growth rate itself. Therefore, unless fiscal imbalances and thus real interest rates are significantly reduced, India will be in a debt trap and will not be able to maintain the current mix of low inflation and relatively high growth. It is therefore not surprising that, as recognized in the Common Minimum Program, and highlighted in the last few Economic Surveys of the Ministry of Finance, and Annual Reports of the RBI, excessively large financial imbalances at the level of the Central Government, State Governments, and public enterprises are the single most important economic management issue facing the authorities. The consolidated deficit of the central government, state and public enterprises amounts to about 10 percent of GDP. This is only 2 percent of GDP below the level prevailing at the beginning of the liberalization process because the Central Government is the only part of the public sector that has adjusted its finances. Fiscal imbalances have remained basically unchanged for states and public enterprises--and their savings have in fact deteriorated. These trends are not sustainable. To stabilize public sector debt in relation to GDP, maintain inflation at below 6 percent and growth at 6-7 percent would require the consolidated public sector primary deficit to be reduced immediately by 1.5 percentage points from its 1995-96 level of 3.1 percent. If the central government were the only part of the public sector to adjust, this would mean a central governmentfiscal deficit of about 4.5 percent of GDP, that is a fiscal correction of 0.5 percent of GDP beyond what is envisaged in the 1996-97 budget. To the extent that states and public enterprises increase their financial performance and reduce their claims on the country's savings, the required fiscal adjustment is correspondingly less. However, as the financial sector is liberalized and banks have more discretion on portfolio composition, there will inevitably be pressure on real interest rates to increase--implying an increase in central government interest payments. Higher real interest rates would reduce private investment and thus growth while, if monetized, the increase in the central government interest payments would increase inflation. To avoid these two negative consequences, a further fiscal adjustment of about 1 percent of GDP is needed--making it necessary to increase the fiscal correction to 2.5 percent of GDP, implying a reduction in the central government fiscal deficit to around 3.5 percent of GDP. A more ambitious fiscal scenario is warranted and feasible, however--in which the consolidated public sector savings increase by 6 percent of GDP over the next four to five years. This would allow fiscal imbalances to be brought to sustainable levels while generating resources for critically needed public investment, and could enable growth to be sustained at 7  - xxvii - percent per year until the end of the decade before increasing possibly to over 8 percent thereafter. The essential elements of a medium-term fiscal adjustment strategy. Any significant structural fiscal consolidation will need to rely on both raising the public sector's revenue effort as well as reducing expenditure and improving its quality. Consolidation of the central government finances is likely to include the following elements: (a) a reduction-cum-retargeting of subsidies, in particular the fertilizer and food subsidy--the latter may require an overhaul of the current PDS and Food Corporation of India; (b) gradual contraction of central government employment, mainly through attrition and associated operating expenditures; (c) commercialization-cum-privatization of public enterprises, including banks and other financial institutions; and (d) improvement in public expenditure management. Improvement of State finances will likely require actions to: (a) increase recovery of expenditure on O&M for irrigation and water supply; (b) reduce power subsidies through an increase in tariffs for agricultural users and households; (c) reduce power theft and improve tariff collections; (d) reduce overstaffing; and (e) broaden the base of taxation, in particular to include agriculture-- according to the Constitution only the states can tax income generated in agriculture and, with few exceptions, most states chose not to tax it. A reduction of central government financial assistance to the states--particularly of those items on which fiscal discipline is the most difficult to enforce, such as the on-lending of deposits in the postal small-savings accounts and the different centrally sponsored expenditure schemes should also be considered, although it is not discussed here. These measures can be implemented only gradually, however, and their full effect will not begin to materialize before the end of the decade. Therefore, correcting fiscal imbalances requires further tax efforts of the kind recommended by the Chelliah Committee on tax reform--in particular, it is estimated that further reform of corporate taxation could increase tax revenue by at least one percent of GDP. Full fiscal consolidation will be difficult, however, without a restructuring of center- states fiscal relations. Expenditure responsibility assigned to state governments by the Constitution accounts for about one half of total general government expenditure. At the same time, states are assigned taxation powers that result in their collecting only one-third of total tax revenues. The difference is covered by transfers in the form of shared central revenue, grants and loans. Since a part of these transfers is determined by the states' gap, and there have been periodic write-offs; states have in practice been faced with a relatively soft budget constraint-- even though in theory state deficits are constrained by limits on borrowing imposed by the central government. More importantly perhaps, states do not face the discipline of financial markets, as the annual program of state security issues is still allocated administratively among commercial banks by the RBI. Thus, all the states borrow on the same terms, regardless of their creditworthiness. It is clear that center-state fiscal relations will need to be restructured if the states are to be encouraged to address their major problems of weak tax collections, growing wage bills, uneconomic enterprises and poor cost recovery. Similar considerations apply to the financial relationships between state and local governments.  - xxviii - Addressing Structural Constraints Besides completing the reforms initiated in 1991, there also is an urgent need to extend reforms to other areas of the economy. As highlighted in the Common Minimum Program, a comprehensive reform of agricultural policies is essential to broaden the base of growth, increase agricultural productivity, and improve the living standards of India's poor--the vast majority of which live and work in the rural areas. As amply recognized in India, and reiterated in the Common Minimum Program, the inadequacy of existing infrastructure is emerging as one of India's most serious constraints to faster growth--and even a constraint to the maintenance of the current levels of growth. There is no simple response to the country's infrastructure problems--and any sensible response will have to be based on a variety of initiatives and innovations involving the financial sector, state and local governments, and the private sector. Similarly, urban reform--whereby India's cities and towns are endowed with the financial capacity to overcome chronic underinvestment in urban areas and supply critically needed urban services--is also emerging as an area for priority action. Finally, as discussed in the last two CEMs, it is urgent to accelerate the development of India's human resources by intensifying recent initiatives in the areas of primary health and primary education. Completing the reforms started in 1991. Significant measures have been taken over the last five years to liberalize the investment and trade regimes and much has been accomplished. That said, a number of steps remain to be taken in these areas. Regarding the investment regime, regulations continue to restrict investment in small scale industries because the Government has been concerned with the employment consequences of a full liberalization of the sector. While this concern is legitimate, studies in India and elsewhere suggest that small scale industries benefit more from adequate access to infrastructure, finance, and imported inputs, than protection from competition. There is also evidence that the economic costs of size limitation in agro- industry are considerable and this is likely to be the case in other industrial areas. Other restrictions such as those applying to the expansion of private banks need also to be eliminated. Regarding the trade regime, it will be important for India to continue to lower tariffs to be able to compete with the more open economies of East Asia, Latin America, and the emerging European former socialist economies, and also to provide a stronger foundation to India's growth process. At present, Indian producers continue to pay higher costs for capital goods and intermediate inputs than their competitors. In addition, important anomalies persist in the tariff structure that can only be corrected by a significant reduction of tariffs. Similarly, the elimination of import licensing restrictions on consumer goods is extremely important to protect the interests of the Indian consumers. In addition, several empirical studies show that the growth impact of foreign direct investment under high protection is smaller than that expected under more competitive conditions. In particular, because of the large size of India's markets, unless they are subject to international competition, domestic producers will have little incentive to be export-oriented and this may delay India's integration into the world market. It will be critically important to complete rapidly the financial sector reforms started in 1991. This is necessary not only to promote the efficient allocation of investments needed to  - xxix - achieve higher growth, but also to strengthen the implementation of both fiscal and monetary policies and preserve macroeconomic stability. However, some of the most important remaining aspects of financial sector reform can only be implemented if fiscal consolidation is achieved because further liberalization in the presence of large public sector borrowings and consequently high interest rates could weaken the financial system--as company balance sheets deteriorate and non-performing assets of banks rise. Assuming that fiscal consolidation is achieved, four financial sector reforms are of priority. First, the restructuring of the public banks needs to be brought to its logical conclusion. This means granting these banks increased managerial autonomy over branch networks, employment and compensation issues, as well as portfolio decisions. In this context, reducing the Government's equity share in these banks below 50 percent would create strong incentives for improved bank management and profitability. This would have to go hand in hand with strengthening the Government's oversight capacity. Second, remaining controls on banks' and insurance companies' portfolios need to be phased out and forced holdings of government debt should be reduced pari-pasu with the development of markets for government debt. Third, as the fiscal deficit is reduced, it should be possible to accelerate the development of money markets by reducing the intervention of the RBI in the placement of government debt and by reducing restrictions on insurance and pensions funds investment decisions. This should make it possible to establish liquid and deep money markets which can provide the basis for benchmark interest rates, help develop financial market linkages, and support development of a corporate debt market. Fourth, the Government will need to continue strengthening prudential regulations, supervision, capital market infrastructure, and legal and regulatory framework. A delivery- versus-payment system was recently established for government securities, but further efforts are needed to create modem settlement and registration systems for corporate bond markets, while regulatory oversight needs to be made more effective. In addition, improvements in India's payments system are essential to the integration of the country's regional financial and non- financial markets, and also for better management of the country's scarce financial resources. The Chelliah Committee on tax reform produced a well conceived program of reforms for the Central Government taxes aimed at broadening the tax base, lowering rates, and streamlining the rate structure--thus providing a basis for improvements in tax administration. A part of the agenda set by this Committee has already been implemented and some of the most severe distortions of the tax system have been corrected. It should now be possible to concentrate on further enhancing the contribution of each tax and on strengthening institutional capacity in this area. In particular, it will be important to extend the base of the excise system. Exemptions have increased in recent years, and long-standing exemptions above reasonable thresholds for the small-scale industry encourage tax evasion and the inefficient fragmentation of production. Correcting this, and reducing the rates to no more than two or three could bring the excise system closer to a value added tax, and facilitate its integration with the critically needed establishment of VATs at the state level. There also is considerable scope to increase the efficiency of corporate income taxation, as well as revenues, by reducing both the rates and exemptions associated with this tax and  - xxx - introducing an alternative minimum tax on gross corporate assets. The exclusion of profits arising from export sales, accelerated depreciation, fringe benefits and other tax preferences imply that a nominal rate of 46 percent (including a 15 percent surcharge) translates into an effective rate of less than 20 percent--with the result that the surge in corporate profits of the last few years has not been accompanied by corresponding increases in tax revenue. While the Minimum Alternate Tax introduced in the last budget will correct some of this, it will be unable to address under-reporting problems associated with transfer pricing and other methods of under- reporting profits. Similar considerations apply to the personal income tax. Particularly important in this regard is the exemption of agricultural income by the states--to whom the Constitution delegates its taxation. To facilitate its political acceptability, effective taxation of this income would require improved delivery of economic services and infrastructure in rural areas by local governments in the context of the on-going decentralization. Last but not least, critically important to the improvement of India's taxation system is the implementation of the recommendation of the Tenth Finance Commission to shift the base for revenue sharing from a high share of two taxes at present (personal income taxes and excises) to a lower share of total tax receipts--which would provide states more stable revenue streams while no longer influencing how the central government raises revenue. Reforming Agriculture. The performance of agriculture is central to the welfare of the over 300 million poor who live and work in rural areas. Increasing agricultural productivity has been a central objective of India's development strategy--essential to the elimination of famines, reduction of poverty, and successful industrialization. Before 1991, the two conflicting objectives of ensuring food supplies to consumers at low prices, and making production remunerative to farmers led to a complex set of policies. Farmers were penalized by: (a) the high protection granted to manufacturing which meant that they had to pay for essential machinery and inputs higher than international prices; (b) overvalued exchange rates that affected negatively the domestic terms of trade for agriculture; (c) restrictions on exports of agricultural commodities which meant that producer prices were generally below their international equivalent; and (d) an extremely complex set of domestic regulations on the trade of agricultural and agro-industrial products aimed at reducing the ability of large traders to influence domestic prices, which penalized farmers by increasing the wedge between farm gate and consumer prices. The price distortions created by these policies resulted in misallocation of resources and production patterns that did not fully correspond to the country's comparative advantage. On the other hand, farmers benefited from large public spending for infrastructure (irrigation schemes, rural roads), support services (research and extension) and subsidies (for fertilizer, credit, water and power for irrigation pumping). No country in the world spends as much on agriculture as India--over one-fourth of agricultural GDP. These policies helped agricultural growth and contributed to the eradication of once chronic famines. The results were particularly noticeable in the 1 980s when, for the first time in India's history, agriculture grew at a significantly higher rate than the population. Since 1980 agricultural growth has increased and spread across regions (to the East), crops and agricultural activities. Because it was scale neutral, and it increased real rural wages, it contributed to an important reduction in poverty. The driving  - xxxi - force behind this trend was the massive subsidization of agricultural inputs, including rural credit, and the protection afforded to oilseeds at least until 1991. The exchange rate policy and the protection of the manufacturing sector prevailing until then on the other hand actually lowered agricultural prices by 25 percent in relation to the industrial and service sectors. Accelerating a trend started in the mid-1980s, the 1991 economy-wide reforms virtually eliminated the anti-agricultural bias implicit in the trade and foreign exchange regime. This, the large amount of public resources spent on agriculture (8 percent of GDP), and an unprecedented sequence of good monsoons explain the rapid growth of agriculture since 1991. However, the much needed fiscal adjustment makes it important to device a "quality" agricultural reform program to support agricultural growth that is not so demanding in terms of fiscal resources. Such a program would consist of four essential components. Thefirst would consist of fiscal measures reducing unsustainable subsidies pari-pasu with measures increasing productive public expenditure (on research, extension, roads, irrigation, and other infrastructure important for agricultural productivity). The second would consist of a comprehensive deregulation of domestic agricultural trade and agro-processing. Such deregulation would significantly reduce marketing and processing margins to the benefit of both farmers and consumers. It would increase rural incomes and accelerate productivity growth. The gains of deregulation are particularly important in the case of rice, sugar, oilseeds, cotton, and livestock. The ratification of the Trade Related Aspects of Intellectual Property Rights (TRIPs) agreement should be an essential element of a deregulation strategy because it would improve farmers' access to productivity enhancing technologies. The third would consist of fundamental reform of the rural credit system--now decapitalized and inefficient. It should be recognized, however, that the elimination of subsidies and the deregulation of external and domestic agricultural trade could have negative distributive implications, at least during a transitional period. Therefore, the necessary fourth prong of an agriculture reform strategy consists of measures to improve the targeting of the existing subsidy programs while reducing their overall fiscal cost. The reform of agriculture is a complex and time consuming undertaking which will need careful coordination. Responsibilities for reform are spread almost equally across the central and state governments, as well as multiple agencies at both the central and state levels. Overcoming the coordination problem would require a strong, shared commitment and consensus about the objectives of the reform program. The reform of expenditure programs for agriculture will need to be underpinned by structural reforms. For, example, rehabilitation and modernization of medium and large irrigation schemes are needed to restore reliability of water delivery without which farmers will be reluctant to pay higher charges. It would also permit volumetric pricing of water and improved water management practices as recommended by the 1992 Report of the Committee on Pricing of Irrigation Water. Institutional reforms are also needed to provide the basis and necessary financial incentives for improved cost recovery as well as improved accountability in the delivery of water farmers. Tamil Nadu and Orissa have recently initiated reforms that would lead to improved cost recovery, quality of service delivery to farmers, and systems turnover to  - xxxii - beneficiaries. Karnataka, in its 1995 Agricultural Policy Resolution, is proposing radically to transform institutional incentives in the irrigation sector by turning the Irrigation Departments into financially and managerially autonomous entities responsible and accountable to water users. India is facing an imminent crisis in infrastructure. An unprecedented power supply deficit, and growing freight transport congestion problems (in roads, ports, and railways), threaten to undermine the supply response to the country's stabilization and reform efforts. To address the major infrastructure needs, the 1991-96 reforms ended decades of public sector monopolies (with the exception of railways), and the government has invited the private sector to play a significant role in raising the level of infrastructure investment and the efficiency of infrastructure services. The response of the shipping industry and air transport has been strong and positive--with dramatic improvements in the quantity and quality of services. In telecommunications, private operators have been inducted in cellular services and other private services are expected to be licensed shortly. In July 1996, a bill for the creation of the independent Telecom Regulatory Authority of India (TRAI) was presented to Parliament and is awaiting approval. Significant private investments would be encouraged by the timely establishment of TRAI. However, in other critical areas such as power (except for captive capacity), roads, and ports, few private investments have been brought to closure under the new national policies. The fundamental obstacle to private sector investment in the power sector is the weak financial position of the State Electricity Boards (SEBs) which operate virtually all the country's distribution networks through which the power supplied by potential private investors would have to be sold. At this time, the SEBs are not financially viable clients for potential private power producers. The SEBs generally are prevented by their respective state government from charging commercially viable tariffs; they are not allowed to cut power from non-paying customers, and many of them are institutionally too weak to contain power theft in rural and urban areas. As a result, the SEBs' financial condition is one of the country's most serious structural constraints to the reduction of the public sector deficit. To alleviate the power supply crisis in the short-run, the government has encouraged captive plants (based on liquid hydrocarbons) where the purchaser is one or more selected industrial consumers. While this approach alleviates the short-term supply constraints, it exacerbates the financial problems of the SEBs by making them loose their best paying customers. Some states (Orissa) are beginning to address these problems through cautious tariff adjustments and through the phased privatization of distribution. But most have yet to begin meaningful power sector reform. In this context, and given growing power shortages in most states, the central government has been concerned to bring to closure at least some of the more viable independent power producers (IPPs) proposals. To that effect, it has committed itself to provide counterguarantees to selected power purchasing agreements between SEBs and IPPs, thereby adding its creditworthiness to the insufficient creditworthiness of the respective state and SEB. Since 1995 the Government has refrained from adding to its pending contracts to extend counterguarantees to IPPs because of the considerable contingent liability which these guarantees create for the Central Government.  - xxxiii - In the case of highways, the international experience suggests that private investment can only be a solution in a few, albeit important, high density corridors, bridges and by-passes. Cost- effective public investment is therefore needed to improve India's road network. The National Highway Authority of India (NHA4I) has been mandated to manage the e-xpansion of the highway sector. Although it lacks the skills and finances to develop a modem capacity for highway construction and up-grading, there is considerable scope for private participation in road design, construction, and maintenance. The traditional reliance on state-level Public Work Departments (PWDs) and small labor-intensive road contractors does not provide the capacity to carry out the urgently needed construction program. Without major reforms in the way in which highway construction is designed, procured and managed, India will be unable to overcome the emerging road transport crisis and utilize the substantial funding potentially available for this purpose from multilateral and bilateral development agencies. MOST is just beginning to take steps to induct private investment into the ports-sub- sector. To date, concrete actions in support of private investment in ports have largely come from state governments. For instance, the Government of Maharashtra has sponsored techno- economic feasibility studies for developing about 30 intermediate and minor ports in the state. Similarly, the Gujarat Maritime Board has initiated such studies for the development of new ports. Thus, the private sector has preferred to deal with the minor ports under the various state governments rather than to deal with the big ports under MOST. In addition, the private sector has taken advantage of the recent deregulation of coastal shipping to set up bulk domestic shipping operations in coal, fertilizer and cement to shift cargo off the congested road and rail systems onto previously underutilized coastal shipping lines. As in the case of power, however, this is not a fully effective way of addressing the sector's problems. Several lessons have emerged from India's experience with the involvement of the private sector in infrastructure. In particular: (a) processes for selection of developers need to be predictable and based on rules that are transparent; (b) projects proposed by government to the private sector need to be preceded by high quality preparatory work covering their technical, social and environmental aspects; (c) the existence of a transparent regulatory framework is critical for the efficient induction of private operators and for the commercial operation of the projects they undertake; and (d) guarantees, counterguarantees, escrow accounts and other financial arrangements are no substitute for an adequate policy and institutional framework providing the basis for predictable revenue streams and financially viable buyers. Urban Reforms There is growing evidence that India's cities and towns are facing a crisis of serious proportions stemming from chronic underinvestment in urban areas and consequent shortages of key urban services. At the heart of the problem are the cities' weak fiscal base--eroded by state legislation imposing rent controls, limits on the amount of land an individual can hold, restrictions on land markets, and unrealistically low water charges. In some of the main cities, revenues are excessively dependent on extremely inefficient taxes which need to be eliminated--such as octroi. Thus, any program of urban reform would need to include measures to: (a) improve urban areas' use of the existing resource base (such as a better cost recovery and enforcement of existing taxes); (b) strengthen the resource base and make it more  - xxxiv - efficient (such as lifting rent controls in the major cities, eliminating octroi, establishing efficient land markets with an effective system of land titling); and (c) establish a rule-based, efficient system of capital transfers to replace the present system. Such measures would provide the basis for the restoration of the finances of the country's cities and towns--and thus restore their capacity to invest in critically needed infrastructure. Over time, they would help municipalities become creditworthy borrowers, able to access capital markets and mobilize financing for critically needed investments. External Financing Requirements As of March 1995, India's US$99 billion external debt is, in net present value terms, more than twice the value of the country's exports. Based on this, the World Bank debt tables classify India, together with Indonesia and Chile as "moderately indebted". Of the world's two major credit rating agencies, only one has rated India's sovereign foreign currency debt above investment grade. In response to this, the authorities have adopted a prudent approach to the management of the capital account. Since the 1990-91 crisis, they have placed considerable emphasis on achieving a strong balance of payments position with a lower indebtedness and debt service ratio. Consistent with these objectives, and an indirect way of influencing the size of the current account deficit, the authorities have brought different degrees of liberalization to different types of capital inflows--depending on their contribution to the country's development, their potential volatility, interest cost, maturity profile, and risk sharing features. Thus, while there are virtually no restrictions on foreign direct investment, there are some on portfolio investment. In particular, although there are no limits on the total amount of investment by foreign institutional investors, there are restrictions related to the type of financial assets they can hold (for example, they cannot invest in government papers, nor can they hold more than 30 percent of their portfolio in debt papers) and to their equity holdings (they cannot hold equity positions which exceed 24 percent of a firm's total equity). Equivalent restrictions apply to Indian firms issuing equity or debt abroad. The rationale for these limitations is that while portfolio investment is attractive for the country because its servicing is not fixed and the foreign investors share the risks associated with fluctuations in domestic income and exchange rates, it does create long- term claims on the country' s foreign exchange resources. Thus, its growth needs to remain in line with the growth in India's capacity to service it--that is in line with export growth. In the case of commercial borrowing, an indicative ceiling is set annually (US$5 billion in 1995-96) and, based on published guidelines and criteria, discretionary authority is used to direct borrowing to priority areas, and to limit short-term borrowing. The authorities see full capital account liberalization as a medium-term objective, to be reached after a sustainable fiscal framework is firmly in place, and financial sector reforms are completed. They have wisely resisted the temptation to relax restrictions on external commercial borrowing over the past year as a means of relieving pressure on domestic interest rates. This would have not only diminished pressure for the urgently needed fiscal correction, but could have also stimulated a destabilizing consumption boom.  - xxxv - One consequence of this self-imposed discipline is that, for the foreseeable future, India will mostly need to rely on foreign direct investment and assistance from external development agencies to meet its substantial needs for infrastructure and human resource development. Therefore, this report continues to make a case for India's sustained access to long-term development assistance, including a substantial concessional component. With a modest current account deficit of 2 percent of GDP over the next few years, India would still require total gross financing of about US$8 billion in 1995-96, and an average of about US$13 billion in each of the following four years. Over the last two years, bilateral and multilateral participants in the India Development Forum have pledged about US$6.5 billion in official assistance as a recognition of India's strong commitment to reform and poverty reduction. Over the last few years, the Government has taken several specific measures to improve the utilization of ODA: (a) advance release of funds are being made to state governments; (b) procedures for awarding contracts and procurement have been streamlined; and (c) a central Project Management Unit has been established in the Department of Economic Affairs, Ministry of Finance, for better portfolio management and project implementation. While these measures have accelerated aid disbursments, there remains scope for further improvements. In conclusion, the Bank would advise the participants of the IDF to support India's ongoing fiscal adjustment and structural reforms through long-term official development assistance for high priority public investments in physical infrastructure and human capital development. With sustained improvements in the utilization of such aid commitments and gradual recourse to debt and non-debt commercial sources, India's remaining external financing needs would be met.  I  PART I FIVE YEARS OF STABILIZATION AND REFORM A SUMMING UP  I  - 3 - n ~~~FROM CRISIS TO GROWTH INTRODUCTION India Has Fundamentally Altered Its Development Paradigm Over the four decades after Independence, India followed a planned development strategy based on extensive public ownership of commercial assets; a complex industrial licensing system; substantial protection against imports (including some of the world's highest tariffs on imports of capital goods, and a ban on imports of consumer goods); restrictions on exports; virtual prohibition of foreign investment; and extensive regulation of financial intermediation. At some point in the 1970s and early 1980s, these policies enabled the government to control the most basic business decision down to the firm level. Thus, while India's private sector has always been important and produced at least two-thirds of GDP, its activities were restricted and used for the goals of a planned development process. This development strategy helped the country escape from the massive illiteracy, recurrent famines, fertility rates of about 7 children per woman, and secular stagnation prevailing before Independence. However, it also was the source of severe financial imbalances which are yet to be corrected. It isolated the country from the rest of the world with the result that from 2 percent in the 1950s, India's share of world trade had declined to less than half of one percent in the late 1980s. It forced Indian consumers to pay higher prices for goods of lower quality and deprived the country from the benefits of foreign direct investment and modem technology. It discouraged production for exports, created recurrent shortages of foreign exchange, and made the balance of payments extremely vulnerable to external circumstances. Most important of all, it held back the country's growth and thus the pace at which poverty could have been reduced. As argued by India's own eminent economists, among them Bhagwati (1993), low productivity rather than inadequate savings explains the weak growth performance of the past decades. Throughout most of this period, macroeconomic policies were conservative and, except for a few episodes associated with unfavorable harvests or external shocks, inflation was contained to single digits. External current account deficits were modest and financed primarily by concessional aid flows. During the 1980s however, and driven by an unprecedented surge in  -4- The People. India ~is a' country of striking contrasts and enormous ethnic, linguistic and cultural diversity. There are more tanr 1600 languages, nearl ~400 of which are ispoken by ~more than 200,000 people,. The dominant religion ~is 1Hindtiism.(2TOren o0f ~the poplation), which ftjho . ts cate system, has prfoundly afecte the nation's social Structur. MusIisacon for sizable ii1 percenit of the populationh, while Christians, Sikhs, Buddhists, ains and Parsis account for the balance India: ranks first in the world in terms of the number Added to Its population each year,~ currently about 16 million~ The total popuaton estimate in mid-1996 at 31 million,is second only to China, Since independence, successive govermentts hae tknsest improve the socio-ecoonomic status~ of the nation's tribal peoples and the lowest subcastes. Designated officially AS scheduled castes (SCs) and scheduled tribes (STs), these groups number over 206 mnillion (1991). STs Are scattered throug houth country, but tend to live in reatively inaccessible areas, 'including forests, hills and deserts. SCs 'areia dispersd group, vayn from predominantly rural to exclusively urban, Both groups, despit constituitional protection, far Proportionately w lsbta the population as~ a whole in areas of health, nutrition, education and iemplomet. Poverly and tradition have also produced severe gender~ ineqalhitie Despite some imnprovement, India's femnale, population~ continues to face higher malnourishment land lower levels of education than men. The sex ratio is disiitubingly~ male-biased, ait 929 female,sperl1,000males. Unlikermost counItries in. Indiw moe omnthanmndebfr h g f3.Fml lieay a~ national: problem,~ is particularly acute in rural areas, within certain state districtsl, and among11 SCIST. Generally lackintgjland,: women remain: locked out of: the formal finiancial system and are Constrained in their ability to acquire 'capital assets:or working capital. These, and other in equalities ~continuelto conlstrain attempts~ to improve labor productivity, reduce fertility, alleviate poverty and prompte accelerated~ economnic: gWth. Urban patterns~ vary widely althugh~ Maharashtra, West Bengal, TailNd and Knaaka hae Comparatively hher uran ratios than the other' states. Bombay ~(12.6 mrrillioni) and Calcuttal(11.0 million) rankamong Jhe:30 larest citiesint4he wold Nonjethless, the country has: not experienced th raid Iualurani migrto tyiaof ohr deeopinglnation.sin Asa Infc about:60'pWocent f alljodians:still ive in villages with fewer than ~5,00.0 people. Edcto,India possesses alarge pool of highly qualified manpDower,.:incIuding buins poesna,engineers and scienst of internaional ~caliber.: However,~ these. groups represent only~ a tiny: fraction of the population. As: a whole, the Country faces. uinacceptably ~highI levels of illiterc and lo le hnn acieveent. More than haf the overall populaition '0ver 15 and: two- thirds of all Women overJ 'SArc illilterate. In addition, the average, educational attainmn of the Adult lao orei6nly 2.4 years. While. most childrcn enroll at the beginninig'fpriunary schoo,more tben ~halMf of rural students drop out beforecompltng the cycle, while only: a third of females make it 'to the~ second.aIry level. Overall, About 33 percent of children~ who should be in. schol ar no-enrlle, wih a ispoporion te nmbr nationiwide comiing from the poorest households", girls,I and SC/STs Healt, There have 'been substantial .gains in health over the piast 40 years Much remains to be done. Infant mortalityvrates~ vary ~widelY by'state;:f,.o.mI 13 per thousandn inKeala'to'l10~ pe'thousand~ in Orissa. The averg forlo incecon trits (excludingiChina and India) is:91 :per thousand. Thei risk 'Of death for children under' yas'of'ag rean hg,a 12.4 percen,about 30 percent higher than'the averagerisk faced ~byte-world':s ~population '~and higher than in all reionsof the world~.... except Sub-saharan Afria. The frequency antd severity of maternal ~morbidity--400 deaths per ID00000..lie births-- is disttessing',, and comares unf~avoraby wit allbta. ml numbe ofcountris. agl preventable communicable deae accun for high shar. ~of deaths: in. the~ coulntry, curbently~ around 470 per' '100,000, :This, is'~int conftrast' to :117 per: 100,000 in China and 187 per 10,0,000 for the world as~ a~ whole. Nutrition, India: has, made :signficant improvements in fod~ Availability ~and distribution, rendering~ ifamines, even iti droughti A: thing of the, past.: However, much remains to be::done in improving nutrition withint regions and among vaiuroupS.Bytae severe: malnutrition~ is: prevalenit in Bihar, ~Utata Pradesh, Madhya Pradesh, etKer V,Ws BnAl, Oris andRajshn C n Ssj re-cord lower level,s ofi nutrienit intake thanft the~ averae for othe goups ad beo recmmnded levesinalstead locations:- ruala wel sura, eder discriminatio infood intakeo ocus n sms icrible] among youg girs in th northern sates. Overall, nearl two-tirds of children under five are mialnourished, and abouta: third& of: newborns are::oflow. birthweight. public investment, fiscal policies became more expansionary. The overall public sector deficit widened from about 9 percent of GDP at the beginning of the I 980s to 12 pprcent of GDP by the end of the decade. Expansionary aggregate demand policies combined with some improvement in productivity in response to the gradual liberalization, produced annual growth of almost 6  percent. This was unsustainable, however. By 1990-91, inflation increased to 10.3 percent, and the external current account deficit reached 3 percent of GDP (US$10 billion), with increasing reliance on short-term capital inflows to finance it. The fragility of the economic situation was exposed when India was faced with the consequences of the Middle East crisis and a period of frequent changes in government which created political uncertainty and delayed the correction of the serious internal and external imbalances. As India's credit standing in international capital markets fell sharply, access to external capital borrowing dried up and substantial amounts of private capital left the country. The result was that India had to face one of its most serious foreign exchange crisis. In June 1991, in spite of a severe squeeze on imports and emergency financing from the IMF, the World Bank, and other bilaterals, particularly Japan, with reserves at less than US$1 billion, the country was on the verge of defaulting on its external debt obligations. The new govemnment that came to power in June 1991 responded to the crisis by stabilization and reform measures intended not only to correct the unsustainable macroeconomic policies of the 1980s, but also to address long-standing constraints to higher economic growth. Over the last five years, changes of the investment, exchange-rate and trade regimes, the financial sector, and the tax system have ended four decades of development policies based on planning and have initiated a quiet economic revolution. With these reforms, India is now closer to the growing group of countries which, starting in the 1970s and 1980s, have gradually but persistently liberalized their economic policies, increased their integration with the global economy, and reduced the role of government. India did not have the inflation, external debt, and social inequities so severe as in Latin America--and was thus able to stabilize the economy more rapidly and at a lower social cost. Unlike former centrally planned economies in Eastern Europe and elsewhere in Asia, India already had an important private sector and all the institutions of a free market economy. India was thus able to avoid the costly industrial and financial closures and restructurings, so frequent and so painful in most of the former socialist economies of Europe and Central Asia, and which have considerably delayed the supply response to reforms. On the other hand, because India's macroeconomic crisis was considerably less traumatic than in Latin America, it has been much harder to reach political consensus on the need to reduce fiscal imbalances to the levels achieved for instance by Latin American, East Asian and Western European countries. And fiscal imbalances remain the single most important threat to India's long term growth. Similarly, notwithstanding five rounds of trade reforms, India's trade protection remains among the world's highest. Likewise and in spite of five years of liberalization, excessive regulation remains a problem particularly in the financial sector, agriculture and agroindustry. In addition, in the financial sector, the public sector continues to be the major shareholder of India's largest banks, insurance companies, and contractual savings institutions raising questions on how truly autonomous these institutions can be. Finally, the development of India's human resources has been slow in comparison with countries in East Asia or Eastern Europe.  - 6 - MACROECONOMIC DEVELOPMENTS An Unexpectedly Strong Recovery The economic recovery has been unexpectedly rapid and robust. Initially, growth declined sharply in response to the devaluation and contractionary fiscal and monetary policies adopted in June 1991 TableL;0 r,t Pe 19146 to address the foreign e..=... exchange crisis India .DPiF 1 .....1981-90 19 0-91 92 19293 1993-94 1 4 95-96 1 996 7 5.5 5.4 0.8 5,1 5.0 ~~~~6.3 ~7.0 6. was then facing. Agricuitue 3i A- 3. -2.3 6. 33 49 . 2.3 From over 5 percent I y 6.9 7.2 -1.3.- 4,2 .3 2. 85 Minn8 Qam~Ing 7,4 10. 3. 4.1 4.3 5.0 in 1990-91, GDP M ng 7.2 6.1: 3.74437 .1 4.3 9 12.2 growth declined to Rtrd80 50 -, , 4.3 . Unregistured 6.1: 7.9 -60 6. . 1.: less than one percent EIetyii, (as., & 89 65 96 83 7 . in 1991-92. The ter recession was struction 4.4 11.6 2.2 3.3 2.3 . .: particularly severe - Not avable._ and prolonged in a. Quick estimates. manufacturing where oe:CO negative growth rates persisted in the main sectors until 1993-94 (Table 1. 1). Helped by reforms, a relaxation in fiscal policies and an unprecedented sequence of good monsoons, growth accelerated to 5 percent in 1992-94, 6 percent in 1994-95 and 7 percent in 1995-96. The industrial recovery has been especially strong, particularly for capital goods (Table 1.2) which !.:-- ITablel1.2: lndex ofInadustrial Producionk 1981.95 had experienced i-0-; 0 Z; ;; ~~~~~~~~~~~~negative growth for Weight1981-91 19.90-91 19.91- 1992-3::1993-94 11994-9 1995-96 ngtv got o Overall In- : ::d:i DiexEiSiE 100.0 7.8 8.2 0.6: 2.3 6::0 9.3 12. three successive gas, Good ~ 394 :7- 38: 6 . , 2 . Caital Gods 16. - 94 11).5-. 170 3j.4 -12.8 -0:.1 -4 .1 2453.9 2-0. years. India has a inteet diates 20.5 6.2 6.1A -0 .7 5 11. 3.17 10.3 capital goods CoasumerQooda --00.023,64 5 6.070 j01i0.40 00-01.8 1.9 4.0 8.7industry which is Dii~~~ab1es . 2.6.3,~~10 14.8~ -12.5: -0.7 16 02 38. o- . ..... . o .. . - .21.0 . 5.7 9.4 t 1.2 2.5 13 8.4: .6.6 unusually large for ~~ AprI~~~-P~~1msa~~~y. ~a country with a :$icOW (i;; - ; CSO;;. ; i j;;;E ifi; ;g;;;; iS;;::E;EW US$350 per capita income, and the severe recession it faced was an important motivation for the less stringent fiscal policies adopted in 1993-94 and 1994-95. Because it has been driven by exports, domestic and foreign private investment, and domestic savings are increasing, the economic recovery is not putting pressure on inflation or the external accounts. India's growth performance over 1991-96 is much better than that of other countries, which underwent stabilization and structural transformation. A time-series analysis (IMF, 1995) of potential GDP and output gaps further indicates that the 1991-93 recession was considerably milder than previous recessions.  - 7 - Growth is being accompanied with productivity improvements. One of the main objectives of India's reform program was to make the industrial sector more efficient and increase its export orientation by dismantling bureaucratic controls over investment and production decisions, giving a greater role to entrepreneurial decision-making, and increasing competition. The available evidence suggests that these objectives are being reached. Industrial growth is being driven by positive structural changes and improvements in productivity, particularly in the industrial sector where there is a sense of a "mini-industrial revolution". In particular, in response to the increase in competition both from domestic firms and from multinationals, corporations are restructuring. Corporate attitudes and cultures are changing, domestic companies are remodeling their operations to become niche players, manufacturing partners, or strategic allies--with a view to strengthening their competitiveness. Reports on individual companies in the organized sector and surveys of firms in the organized and unorganized sectors carried out for this report indicate that restructuring is taking place along several lines. First, some firms are consolidating around core competencies and selling off units unrelated to their core activities. Second, mergers and acquisitions continue to increase in an effort to expand capacity quickly and consolidate market share. Third, a number of companies have entered into strategic partnerships, mostly with foreign companies, to acquire new technologies, management techniques, and access to outside markets. Fourth, taking advantage of the liberalization of financial markets and increased access to international capital markets, firms are reducing interest costs by retiring high-cost domestic debt. Fifth, family-owned and managed companies are changing their organizational structure and professionalizing their management. Finally, some companies are strengthening management and reducing excess labor through training programs and voluntary retirement schemes. As a result, there are clear indications of important efficiency gains. First, in response to the reduction in the anti-export bias implicit in India's pre-1991 trade and exchange rate regime, export and import intensity have increased since 1991 in most sectors (Table 1.3). Easier access to imported capital and Table 1.3 Change in Trade Orientatioo, Profltbility, and Productivity slre 1)91"l Compared to tht prc-19"I Period intermediate goods has Retum to Return to Export Import been particularly Fixed Capital Risk Capital Productivity Intensity Intensity important for this Capital Goods *e -' evolution, especially for Consumer Cyclicals +* 4. X4. : t Consumer Staples e4 t *4 newly emerging agro- Technology 4 * 4. 1 t based industries such as Note: T increase; 4'decrease; ncg no change Souree: NCAER, "Impact of Economic Reforms on Large, Medium and Small Scale Industries in the floriculture, aquaculture, Organized and Unorganized SectDe'. These results ae bad on a survey of over I.000 lage and horticulture. Second, declining mark-ups in most sectors (Table 1.4) suggests that productivity has increased--even after taking into account the influence of cyclical factors on mark-ups. One exception is transport equipment, a sector where import restrictions (particularly on automobiles) remain severe and domestic demand has grown rapidly in the recent past. However, the many new recent entries in this sector are expected to bring new technologies, increase productivity, expand capacity, strengthen competition--and thus offset the impact of cyclical factors on markups. Third, for the past two years, corporate profits have been at record levels. Results for  - 8 - Table IA: Change in Profitability and Productivity since 1991 1569 non-financial companies for the Compadtotheprice-CtlRati Productivity financial year 1995-96 indicate that Electrical Machinery gross margins increased to 16.3 Non-Electrical Machinery t1. o Electronics * .e percent, up from 15.8 percent for Transport equipment t i t 1994-95 (CMIE, June 1996). The Textiles largest improvements in gross profit Chemicals **ipoeet grs !Vote: Trhe sign (4) indicates a decline and (T) an increase. margins have been experienced in (0) indicates that the estimated change is statistically significant at 5% level. such industries as cement and allied Source: P. Balakrishnan, "Economic Reforms, Competition and Productivity Growth in India: A Panel Study of Manufacturing Firms", April 1996. The products, alunimum, glass and study covers over 1,000 large companies. mineral products, hotel and transport services. There also is some evidence, however, that the increase in profits cannot be attributed to productivity gains alone. Access to finance may have played some role. In particular, firms with no access to international finance seem to report lower profits than those that could avoid high domestic interest costs. Fourth, there also is some evidence of improvements in quality. Quality improvements are obviously hard to measure. However, the cumulative number of Indian companies seeking and receiving ISO 9000 certification in recent years has risen from 8 in January 1993 to around 1,200 by May 1996 and survey results indicate that large firms are more concerned about the quality of their products now than they were prior to 1991. The results of surveys of large, medium and small enterprises in the organized and unorganized sectors conducted for this report indicate that the business community is generally supportive of the reforms implemented thus far. In particular, the surveys suggest that: (a) businesses favor the new liberalized environment despite the stiffer competition, only few are skeptical of the benefits; (b) export-oriented businesses are upbeat, they see greater potential for business expansion provided the government adopts a more consistent hands-off policy and concentrates on relieving infrastructure bottlenecks; (c) business complains of still cumbersome administtative procedures for tax returns, duty drawbacks, and other transactions with the public administration; (d) except for import-competing industries, there is a strong desire for faster trade liberalization and tariff reductions especially on raw materials, intermediates and capital goods; and (e) a large number of respondents indicated that the current power charges are too high in view of the quality of service, and expressed their willingness to pay higher rates in return for more reliable power. In general, businessmen were impatient at the slow pace at which administrative and legal reforms are proceeding. Although the reform program did not contain initially an explicit agricultural component, it created a number offavorable conditions for the sector. The stabilization and economy-wide reforms provided an environment favorable to agricultural growth as early as 1992-93 through two channels: (a) the rapid and broad-based economic recovery led to rising domestic incomes which, combined with the improved international competitiveness of primary and processed agricultural commodities (e.g., cotton textiles, oilseed meals, horticultural crops, fish products, leather goods), provided most of the needed impetus to sustain demand for a rapidly increasing supply; and (b) the virtual elimination of the bias against agriculture caused by economy-wide policies. By 1994-95, the devaluation of the rupee and the more open trade regime in manufacturing eliminated the economy-wide discrimination against agriculture which  - 9- along with the successive years of good monsoons translated into an acceleration of growth from negative 2.3 percent in 1991-92 to 4.9 percent in 1994-95. The performance of the agricultural sector is discussed in detail in Chapter 4. The recovery ofprivate investment is being financed mostly by foreign direct investors and domestic savings. As indicated in Table 1.5, foreign direct investment (FDI) has doubled every year since 1991-92. In addition, FDI approvals in 1995-96 increased to US$10 billion. Assuming an average 3-4 years project implementation period, this suggests that actual flows of FDI could reach US$10 billion by the end of the decade. This would still be much less than the about US$30-40 billion of FDI seen in China in recent years. That said, the response of FDI to India's liberalization is similar to what was seen in China five years into the latter's liberalization process. Table 1.5:. Foreign Direct id Port:olio Investment '(US milio,n) 1990s91 1991-92 1992-493 1993-94 1994-95 1995-96P D:iret