India in the global economy

\v/PS IG'I POLICY RESEARCH WORKING PAPER 1681 India in the Global Economy lndiastillisnotattracting attention from foreign investors commensurate with Milan Brahmbhatt its size and economic T. G. Srinivasan potential, nor is its Kim Murrell engagement in world trade keeping pace with that of the more dynamic developing countries - especially comparable countries in East Asia, The World Bank International Economics Department International Economic Analysis and Prospects Division November 1996  POLICY RESEARCH WORKING PAPER 1681 Summary findings Despite considerable improvement in policies and Even with a favorable external environment, under performance in recent years, India's progress toward current policies India is unlikely to achieve the medium- integration in the global economy has been modest. The term targets for growth and exports spelled out in four chief areas of weakness seem to be: government plans. The country is also vulnerable to * Inadequate macroeconomic policies - notably a external and internal shocks. large fiscal deficit that crowds out private investment Reforms should contribute to increasing foreign direc: essential for export success and reduces the confidence of investment and its benefits. Foreign direct investment foreign investors. can help raise the private investment rate without * Higher levels of protection than in other developing incurring additional debt and can help relax key countries. infrastructure constraints. But its greatest long-run * Inefficient transportation and communications benefit may come from its direct and indirect effects in infrastructure. improving productivity. Foreign direct investment has * Poorly equipped sections of the labor force and long been opposed because of fears that it will have ill inflexible labor markets. effects. But such effects are likely to result from policy- In the presence of these policy weaknesses, India's induced distortions, and it is those distortions that large domestic market, which could be a strength, should be addressed. discourages Indian firms and foreign direct investors from focusing enough on export markets. This paper - a product of the International Economic Analysis and Prospects Division, International Economics Department -is part of a larger effort in the department to study the implications of the process of global econom ic integration for developing countries. Copies of the paper are available free from the World Bank, 1818 H Street NWV, Washington, DC 20433. Please contact Sarah Crow, room N4-096, telephone 202-473-0763, fax 202-522-2578, Interr et address scrow@worldbank.org. November 1996. (65 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors' ou,n and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Produced by the Policy Research Dissemination Center  INDIA IN THE GLOBAL ECONOMY Milan Brahmbhatt T.G. Srinivasan Kim Murrell International Economics Department Analysis and Prospects Division This study was prepared under the general direction of Uri Dadush. Significant contributions were also made by Kumiko Imai, Jalal Jalali, Claude Leroy, Tetsuo Umemura and Marcus Williams.  I  Table of Contents EXECUTIVE SUMMARY ....................................................................... 1 SECTION 1. INDIA'S GLOBAL INTEGRATION PERFORMANCE IN INTERNATIONAL PERSPECTIVE ....................................................................... 4 1.1 RECENT MACROECONOMIC PERFORMANCE ....................................................................... 5 1.1.1 Growth ....................................................................... 5 1.1.2 Savings, Investment and External Debt ....................................................................... 6 1.1.3 Fiscal Balances, Inflation and Crowding Out ....................................................................... 8 1.2 PERFORMANCE AND ISSUES IN GLOBAL INTEGRATION ....................................................................... 10 1.2.1 Trade Openness ....................................................................... 10 1.2.2 Trade Restrictions ........................................................................ II 1.2.3 Foreign Direct Investment ....................................................................... 12 1. 2.4 Credit Ratings and Manufactures Export Share ........................................................................,.. 14 SECTION 2. STRENGTHS AND WEAKNESSES IN GLOBAL INTEGRATION ............................ 16 2.1 MACROECONOMIC STABILITY ......................................................................... 16 2.2 TRADE POLICY, EXPORT ORIENTATION AND FDI ....................................................................... 18 2.3 INFRASTRUCTURE CONSTRAINTS .......................................................................1 9 2.4 LABOR MARKET CONSTRAINTS ....................................................................... 23 SECTION 3. EXTERNAL SECTOR OUTLOOK: PROSPECTS FOR KEY SECTORS AND MAIN VULNERABILITIES ........................................................................ 26 3.1 OVERVIEW ......................................................................... 26 3.1.1 The Global Economic Environment and Implications for India . . .................................................... 27 3.1.2 Outlook for Export Earnings ....................................................................... 29 3.2 PROSPECTS FOR SELECTED KEY MERCHANDISE EXPORTS SECTORS . ................................................ 33 3.2.1 Garments ........................................................................ 33 3.2.2 Diamonds ........................................................................ 35 3.2.3 Agricultural Exports ........................................................................ 38 3.3 PROSPECTS FOR SELECTED KEY SERVICE EXPORT SECTORS ............................................................. 40 3.3.1 Software ....................................................................... 40 3.3.2 Tourism ........................................................................ 42 3.3.3 Workers Remittances ....................................................................... 44 3.4 ISSUES IN CAPITAL FLOWS TO INDIA ......................................................................... 45 3.4.1 FDllnflows ....................................................................... 46 3.4.2 Portnfolio Inflows ....................................................................... 47 3.4.3 Official Sources and NRI Deposits ....................................................................... 48 3.5 BALANCE OF PAYMENTS VULNERABILITIES ......................................................................... 49 3.5. 1 Supply Shocks: Agriculture ........................................................................ 49 3.5.2 Supply Shocks: Oil ....................................................................... 49 3.5.3 Interest Rate Shocks and Macroeconomic Instability ..................................................................... 51 SECTION 4. MAXIMIZING THE BENEFITS OF FDI FOR THE INDIAN ECONOMY ................ 53 ANNEX ......................................................................... 58 BIBLIOGRAPHY ....................................................................... 64 i  Table of Tables LI Domestic Savings-Investment Balance 6 1.2 ExternalDebtlndicators 7 1.3 Fiscal Balances 8 1.4 Private Fixed Investment as Percent of GDP 10 2.1 Integration, Policy and Performance, 1984-93 17 2.2 Airport Capacity in International Comparison 21 2.3 Telecommunications Sector Indicators, 1993 22 2.4 International Differences in Strike Activity and its Economic Impact (Average 1980-87) 24 2.5 Scientfi'c and Technical Workers 25 3.1 External Environmentfor India, 1975-2005 28 3.2 Source and Growth of India's Foreign Exchange Earnings 31 3.3 Performance of Key Export Sectors 32 3.4 Software: Cost Savings Using Offshore Labor 41 3.5 Foreign Tourism in India and Comparators 43 3.6 India s Capital Account 46 4.1 Industrial Distribution of FDI Stock _ _S56 Table of Figures 1.1 Real Per-Capita GDP Growth by Regions 5 1.2 Median CPI Inflation, 1984-93 9 1.3 Change in Real Trade Ratios, 1990-93 vs. 1980-83 11 1.4 Average Unweighted Tariff Rates 12 1. 5 Change in FDIas percent of PPP GDP, 1981-83/1991-93 13 1.6 Speed of Integration, early 80's to early 90's 14 2.1 Infrastructure Stocks and Per-Capita GDP 20 Z2 Rail Road Tracks 22 2.3 Hourly Compensation Costs for Production Workers in Manufacturing 23 3.1 Export Market Share for India and Competitors 26 3.2 Comparative Clothing Production Costs, 1995 35 3.3 SITC 667 Pearls, Precious and Semi-Precious Stones. Percent Share of World Exports 36 3.4 Growth of European Tourism Abroad, By Destination, 1989-93. 44 3.5 Private Transfers and Labor Outfflow 45 3.6 Net Capital Flows to India by Debt-Creation Status, 1988-95 47 3.7 Vulnerability Indicators __50 . .  Executive Summary A critical element of the stabilization and reform program launched by the Indian authorities in 1991 is a move from the inward-oriented economic strategy that prevailed over the first 40 years of independence towards an outward-oriented one that seeks to emulate the dynamic experience of the East Asian countries and greatly expand the benefits the Indian economy draws from interaction with the world. These benefits center on greater access to knowledge and technology, the stimulus of competition with world class rivals, resource allocation and welfare gains from being able to trade at world prices and better access to the global pool of savings. These theoretical considerations are supported by a growing body of evidence confirming that the pace and level of integration are in faet associated with more rapid economic growth. This study reviews trends in the process of India's integration into the world economy in the context of the experience of developing countries as a whole and evaluates the main factors which may hamper the pace at which integration occurs in the future. Based on a consideration of prospects for key export sectors the study appraises the prospects for a major improvement in some export sectors targeted by the authorities. Finally, it assesses the potential effects of increased FDI in the Indian economy. The study reaches the following main conclusions: 1. Despite considerable improvement in policies and performance in recent years, international comparisons suggest that India's progress in global integration has been modest and its level of integration remains low. India is still not attracting a level of attention from foreign investors commensurate with its size and economic potential, nor is its level of engagement in world trade keeping pace with that of the more dynamic developing countries - especially the countries in East Asia that appear the most relevant comparators. A variety of indicators suggest that the increase in India's integration with the world economy in the decade to the early 1990s was relatively modest when compared to the fastest integrating developing countries. India's international trade to GDP ratio, one measure of its openness to foreign technology and competition, increased at only about the median rate for all developing countries, while the level of its tariff and other restrictions on trade remained among the highest in the world even after the liberalization of recent years. The ratio of FDI to GDP, another measure of openness to technology and competition, also increased at only the median pace for all developing countries. In particular the increases in India's trade and FDI openness ratios were small compared to those achieved by countries in East Asia and Latin America. Country credit ratings, an indicator of access to international capital markets, fell sharply with the balance of payments crisis of the early 1990s but recovered in the last couple of years. Only in terms of increases in the ratio of manufactures in total exports, another measure of access to technology learning gains, was India's performance in the top quartile of all developing countries. I  2. Comparison of India 's policies with those of fast-integrating developing countries suggests that its moderate performance in the past and modest prospects for the future may be ascribed to four major weaknesses: inadequate macroeconomic policies notably a large fiscal deficit which crowds out private investment essential for export success and adversely affects the confidence of foreign investors; still high levels of protection compared with other developing countries, defects in the transportation and communication infrastructure, especially with respect to efficiency of usage of existing structures; and inadequacies in the quality of large sections of the labor force and the flexibility of labor markets. In the presence of these policy weaknesses, India's large domestic market - potentially a source of strength in furthering integration - serves to further discourage Indian firms and foreign direct investors from giving adequate attention to export markets. The experience of developing countries over the past decade suggests that macroeconomic instability has a particularly adverse impact on the pace of integration, operating in particular through the negative impact of greater uncertainty on investment in general and FDI in particular. While India has performed relatively well in terms of macroeconomic stability indicators such as inflation and inflation volatility so far, its large and chronic fiscal deficit poses a considerable threat to prospects for accelerated integration in the future. India's still relatively high trade restrictions will not only cramp growth in trade openness but are also likely to be negative for FDI. The evidence suggests that while high trade restrictions may draw in a certain volume of "tariff hopping" FDI, an outward oriented strategy drawing on the country's comparative advantages and looking towards global markets will draw in much more over the long haul. An adequate, high quality and efficiently managed infrastructure, particularly in transport and communications, is likely to be a vital resource for integration. Deficiencies in transport and telecommunications infrastructure are a major handicap for India from this perspective. Substantial under-investment, poor maintenance and low operating efficiencies have contributed to significant physical constraints in ports, inland transport links and international aircargo capabilities. Finally, while India's large pool of high- skilled, low-cost, English speaking professionals is an almost unique asset for future integration prospects, the low education level of the population as a whole, and the poor flexibility of labor markets in the organized sector, are likely to prove significant handicaps. 3. Forward-looking analysis ofprospectsfor key export sectors suggests that, despite the expectation of a favorable external environment, India is unlikely, on current policies, to achieve the medium term targets of economic growth and exports incorporated in government plans, and the country will also remain vulnerable to a combination of external and internal shocks. The global economic environment for developing countries is likely to be relatively favorable over the next decade, characterized by higher world output growth than in the 2  1 980s or early 1 990s, rapid growth in world trade, continued expansion of private capital flows to developing countries and moderate inflation and interest rates. Nevertheless, the recent growth rate of around 20 percent per year in India's nominal dollar exports is unlikely to be sustained. Analysis of prospects for key export revenue sources such as garments, gems, agricultural products, software, tourism and worker remittances confirm the significance of previously noted hindrances such as poor infrastructure and trade restrictions and suggest a more modest order of improvement, from around 6.5 percent real growth for current account receipts over the past decade to around 7.5 percent in the next. From the viewpoint of balance of payments vulnerability, while swings in domestic agriculture have greatly diminished, oil price volatility is increasing due to fast demand growth and poor domestic production performance - both of which are closely linked to poor energy sector policies. Further, India's striking success in attracting large volumes of portfolio capital raises the premium on achieving sound macroeconomic policies as a key element in sustaining these flows long term. 4. An important consideration in the design of further reforms is ensuring that they contribute to both a sustained increase in the volume of FDI and in the benefits that the country derives from such inflows. FDI can contribute to raising the private investment rate without incurring additional external debt and to helping relax key infrastructure constraints, but its greatest long-run benefit is likely to derive from its direct and indirect effects in raising the productivity of the economy. Possible ill-effects of FDI, which are sometimes taken to justify long-standing fears or opposition to FDI, may in fact arise as a response to prevailing policy induced distortions and be best treated by addressing the underlying distortions themselves. The liberalization of India's FDI regime is one of the most significant elements of the post 1991 reform program and has generated considerable debate about the potential advantages and ills of FDI. There is indeed a considerable body of evidence for technology "spillover" and other potential gains associated with FDI, but a more interesting question concerns what policies governments can follow to maximize these gains. Recent research suggests that open trade policies may not only encourage FDI inflows but may also increase the technology transfer and other spillover gains a host country may expect to derive from it. There is further evidence that these gains increase with the degree of competition among domestic or local firms. Finally, countries can maximize spillover gains by increasing their own absorptive capacity, through, for example, better education. 3  Section 1. India's Global Integration Performance in International Perspective Despite considerable improvement in policies and performance in recent years, international comparisons suggest that India's progress in global integration has been modest and its level of integration remains low. India is still not attracting a level of attention from foreign investors commensurate with its size and economic potential nor is its level of engagement in world trade keeping pace with that of the more dynamic developing countries - especially the countries in East Asia that appear the most relevant comparators. This is of concern because the pace and level of integration are found to be empirically associated with economic growth and there are good theoretical reasons to expect integration and growth to be mutually enhancing Since the balance of payments crisis of early 1991 the Indian authorities have conducted what has been in many respects a strikingly successful macroeconomic stabilization and structural reform program. A critical element of this program has been a decisive move from the inward-oriented economic strategy that prevailed over the first 40 years of independence towards an outward-oriented one that seeks to emulate the dynamic experience of the East Asian countries and greatly expand the benefits the Indian economy draws from interaction with the world economy. ' Potentially the most important way that integration, meaning participation in international markets for goods, services, capital, and labor, can help enhance economic performance is by raising productivity through access to new technologies, ideas or products, or through the bracing effect of competition with world class rivals. Another is by improving resource allocation and welfare by being able to buy and sell products at world prices according to comparative advantage. A third is by expanding the availability and lowering the cost of resources for investment by broader access to foreign savings. The theoretical links between integration and growth are illustrated by a growing body of empirical work. The World Bank's "Global Economic Prospects and the Developing Countries, 1996" presents evidence that developing countries with the most rapid pace of integration in 1984-93 also experienced a median rate of per capita GDP growth three percentage points greater than those with the slowest pace, while a study by Sachs and Warner (1995) indicates that countries with open policy regimes experienced a similar growth premium over countries with closed regimes. 'The Economic Survey for 1995-96 states "Our policy efforts should draw inspiration and guidance from our fast growing neighbors in East Asia. Over the past two decades the East Asian 'miracle' economies have demonstrated the possibility of sustained economic growth at 8 to 9 percent per year, coupled with strong external sectors and low inflation in the range of 3 to 7 per cent per annum. In order to raise the living standards of India's people and eliminate the scourge of poverty from our country, we must strive to match the performance of the East Asian economies". 4  1.1 Recent Macroeconomic Performance This section starts by reviewing India's macroeconomic performance in international perspective for several reasons. First, as will be argued in more detail later, aspects of macroeconomic performance such as macroeconomic stability exercise a powerful influence on the success with which developing countries integrate with the world economy. Second, India's success with global integration will depend not only on how far macroeconomic perfornance improves relative to its own past but will also be conditioned by the performance of other countries, an increasing number of whom are also embarked on the path of domestic reform and international integration. Finally, a comparative international perspective is likely to assist decision makers in setting targets and benchmarks that are not only realistic but also sufficiently challenging relative to best practice elsewhere. 1.1.1 Growth India's real per-capita output growth rose to 3-4 percent a year in the 1980s from less than 1 percent a year in the 1970s. Over the same period growth for developing countries in the aggregate (excluding transition economies) dropped to around 1 percent from near 3 percent for a variety of reasons including declining terms of trade, the debt crisis and persistence with poor macroeconomic and structural policies (Figure 1 .1). India's growth exceeded that in every developing country region other than East Asia and its growth ranking in a sample of 115 countries (89 developing and 26 developed) jumped from 87th in the 1970s to 13th in the 1980s. Figure 1.1 Real Per-capita GDP Growth by Regions 6.0 - 4.0- 2.0- X u 0.0 - o- -2.0 0- C -4.0.11 l 71-80 .1981-90 01991-95 Fi1e.wlt-yp.xis But, as has been widely noted, the growth surge of the 1980s was accompanied by a deterioration in macroeconomic balances, reflected in rising fiscal and current account deficits. In particular, the accumulation of external debt proved unsustainable, culminating in the 1991 balance of payments crisis. Per capita GDP growth slipped to 5  around 2 percent in 1991-95 (and to 28th rank in the comparative sample of 115 countries) as the country undertook stabilization measures. Though growth returned to the 1980s pace of 3-4 percent in 1994 and 1995 the experience of the 1980s suggests that a key objective of reform is not only to raise growth towards East Asian rates but to achieve it on a sustainable macroeconomic basis, so that another almost unique East Asian characteristic - the persistence of rapid growth over decades at a stretch - can be achieved. 1.1.2 Savings, Investment and External Debt One of the successes of the stabilization effort of the early 1990s was a significant reduction in the domestic resource deficit - the excess of domestic investment over domestic savings - which constitutes a main component of the balance of payments current account deficit. Table 1.1 indicates the resource deficit rose from 0.9 percent of GDP in the 1970s to 2.7 percent in the 1980s as somewhat higher gross domestic savings were inadequate to finance a 4 percentage point rise in the ratio of investment to GDP. One problematic feature of the stabilization of the 1990s is that much of the reduction in the resource deficit to 0.9 percent of GDP in 1991-94 resulted from a lower investment rate, something that, other things equal, is adverse to long term growth. Yet high and rising investment rates, financed largely by high and rising domestic savings rates, have been a critical component in the East Asian growth miracle. India's investment and savings rates in the early 1990s were fully 12-13 percentage points of GDP lower than in East Asia. They were also lower than in MENA, ECA and for LMICs in the aggregate. Table 1.1 Domestic Savings-Investment Balances Gross Domestic Investment Gross Domestic Savings Resource Balance 1971-80 1981-90 1991-94 1971-80 1981-90 1991-94 1971-80 1981-90 1991-94 India 20.1 23.9 22.8 19.2 21.1 21.9 -0.9 -2.7 -1.0 East Asia 25.5 29.8 34.8 25.0 29.8 34.7 -0.5 0.0 -0.1 China 30.0 34.0 37.7 30.1 34.3 39.8 0.1 0.3 2.1 Korea 28.0 30.7 37.1 22.4 32.4 36.5 -5.6 1.7 -0.6 LAC 23.8 20.3 19.9 22.1 22.7 19.3 -1.6 2.4 -0.5 Brazil 23.2 20.6 18.4 20.9 23.4 20.7 -2.1 2.8 2.3 Mexico 21.9 21.3 23.8 19.8 24.9 19.2 -2.1 3.6 -4.5 MENA 26.9 24.3 26.1 38.4 23.0 24.5 8.1 -1.3 -0.8 ECA ... 28.1 24.7 ... 27.9 23.3 0.0 -0.1 -1.4 SSA 23.4 18.7 16.7 22.4 17.9 15.6 -1.0 -0.8 -1.0 Other South 14.9 18.9 19.2 7.5 8.3 12.6 -7.4 -10.6 -6.6 Asia* Pakistan 16.3 18.7 19.8 7.8 9.4 16.4 -8.5 -9.3 -3.4 LMICs 26.0 25.0 25.7 26.4 24.8 24.7 0.3 -0.1 -1.0 Source: World Bank World Tables, 1995. *Simple average of Bangladesh, Pakistan and Sri Lanka for "Other South Asia" The comparison with East Asia also highlights the critical importance of export growth in determining the sustainability of a given savings-investment imbalance. Thailand, which achieved over 6 percent real per capita GDP growth in the 1980s, ran a resource deficit 6  averaging 3.1 percent of GDP in the 1980s, a little larger than India's, while at the same time reducing its ratio of external debt to exports from 97 to 87 percent. This happened because Thailand's exports grew at an average 14 percent a year in nominal dollar terms in this period2, well above the interest rate on its new borrowings of around 6.5 percent.3 India, on the other hand, experienced export growth of 5.6 percent a year in the 1980s, a little below the interest rate on new commitments leading to a big jump in its debt-export ratio from 136 percent in 1980 to 313 percent in 1990. (Table 1.2 below). Though India's debt/export ratio fell sharply with the stabilization of the early 1990s, reaching 248 percent by 1994 as a result of the reduction in the resource deficit and a doubling in export growth in the early 1990s, it remained high in relation to aggregate ratios for East Asia, MNA and ECA and was not much below those for Latin America and Sub-Saharan Africa. Maintaining a sustainable external position in future will depend critically on consolidating the improvement in export growth achieved in recent years, continuing structural reforms to improve the efficiency with which the capital stock is utilized and improving domestic savings to finance a significant part of the higher investment rates required for faster growth. The last will depend to a considerable extent on the prospect for improvement in fiscal imbalances. Table 1.2 External Debt Indicators External Debt to Exports Ratio Debt Service Ratio 1980 1990 1994 1995 1980 1990 1994 1995 India 136.0 313.0 247.5 9.3 30.1 26.3 East Asia 93.6 106.6 93.3 83.3 13.4 15.3 12.0 10.7 China 20.9 87.2 80.4 4.3 11.5 8.9 Indonesia 94.2 222.0 195.8 13.9 31.5 30.0 Korea 130.6 45.2 46.9 19.7 10.7 6.8 Thailand 96.8 87.2 93.0 103.1 18.9 16.3 18.5 15.6 Latin America 206.0 277.4 258.6 254.2 36.9 26.3 27.5 30.3 Brazil 313.3 334.5 298.2 63.5 22.4 31.8 Mexico 250.1 238.8 228.1 47.8 25.9 33.9 MNA 36.8 109.8 148.5 136.9 5.0 14.7 15.4 13.7 ECA 54.6 120.2 153.7 144.6 8.6 16.8 14.6 15.4 SSA 90.9 225.7 265.7 269.8 9.7 17.8 14.0 14.7 Other S. Asia: Pakistan 208.7 249.9 300.4 17.9 23.2 34.8 LMICs 88.3 161.6 162.8 150.0 13.2 18.3 16.6 16.3 Source: World Bank World Debt Tables 1996. 1.1.3 Fiscal Balances, Inflation and Crowding Out Macro stabilization efforts in the wake of the balance of payments crisis of 1991 led at first to a significant reduction in fiscal deficits. The central government deficit fell from 8.4 percent of GDP in 1990-91 to 5.7 percent in 1992-93 but there has been little further 2 Exports of goods and non-factor services inclusive of workers remittances. Thailand's long run debt to exports ratio in this situation, calculated as the deficit divided by the difference between export growth and the interest rate on debt, was about 40%. If export growth is less than the interest rate, the debt to export ratio climbs indefinitely. 7  progress since then. Much of the earlier progress was lost in 1993-94 when the deficit rose to over 7 percent of GDP due to both revenue shortfalls and spending overruns. The Bank's revised projection for 1995-96 still posts the central deficit at 6 percent of GDP. A significant part of this fiscal consolidation was achieved by cuts in capital expenditure. Comparing 1995/96 to 1990/91, lower capital spending contributed 1.1 percentage points of the 2.4 percent of GDP reduction in the central deficit. (Most of the rest was contributed by lower net lending to states). Cuts in current expenditure (e.g., reductions in subsidies) were largely offset by rising interest on debt which rose from 4 to 4.9 percent of GDP. The squeeze on capital spending may be particularly deleterious for long run growth and global integration insofar as it reduces resources for needed infrastructure, especially for transport and communications. Table 1.3 Fiscal Balances Another problematic aspect was General Government Fiscal Deficits that central government (As % of GDP) consolidation efforts were not 1986-90 1991-94 CaDnge adequately matched at the state level. Bank mission statements India -11.4 -9.7 1.7 suggest the general deficit fell East Asia (5) -1.3 -0.1 1.1 from 12 percent in 1990/91 to a Latin America (4) -6.8 0.2 7.0 still high 8.5 percent in 1994/95. Other South Asia (3) -9.2 -7.5 1.7 Increases in unproductive current MNA (3) -6.5 -1.9 4.7 expenditure have also tended to SSA (4) -6.8 -8.8 -2.0 put pressure on investment resources at the state level. A . . ~~~~disturbing feature of recent Note: Regional Values are simple averages. East Asia: trend itat pl i esent China, Indonesia, Korea, Philippines, Thailand. Latin trends IS that public mvestment America: Argentina, Brazil, Chile, Mexico. Other South Asia: in agriculture, which is to a Bangladesh, Pakistan, Sri Lanka. MNA: Algeria, Egypt, Iran. considerable extent a state SSA: Cote d'lvoire, Kenya, Nigeria, South Africa. Source: responsibility, has been stagnant IMF Government Finance Statistics, World Bank Staff in real terms.' Yet, as discussed estimates. further below, a characteristic feature of the East Asian success story is a dynamic agricultural sector, supported, in part, by allocation of a larger share of overall public investment to agriculture than is generally the case for developing countries. In international perspective (Table 1.3) India's fiscal deficits remain among the largest experienced by developing countries, comparable only to those in other South Asian countries and in Sub-Saharan Africa. By 1991-94 major countries in East Asia and Latin America had on average essentially achieved balanced budgets as compared to a continued deficit of around 10 percent of GDP in India. The 1.7 percentage points of GDP fiscal consolidation achieved by India - comparing the early 1990s to the late 1980s 4 See Ahluwalia 8  - was dwarfed by consolidation efforts in Latin America and even in some MNA countries. Experience across a wide range of countries confirms that large, persistent fiscal deficits are the prime source of macroeconomic instability resulting, depending on how they are financed, in some combination of high inflation, crowding out of private sector investment, and pressure on external finances.5 Financing of India's fiscal deficits has largely been accomplished through domestic borrowing from the banking system at below market interest rates (until recently), as well as through external borrowing. Avoiding the monetization of deficits has contributed to relatively controlled inflation which averaged 8.8 percent in 1984-93 at the consumer price level versus a median 11-12 percent for all developing countries. (Figure 1.2). Inflation has however exceeded the 5 percent or so for East Asian countries and, while easing from 12-14 percent during the crisis of the early 1990s, continued to run at around 10 percent in 1994 and 1995. While inflation has been Figure 1.2 Median CPIInflation 1984-93 relatively moderate by 30.0 international standards so far, 25.0 the effects of persistent large fiscal deficits are reflected in 20.0 other indicators. Internal and 15.0 external public sector debt is 10.0 estimated to have risen to 90 percent of GDP compared to a 5.0 median 41 percent in East Asia, 0.0 44 percent in the "Baker 15" C ,;< C ( (