Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15850 PERFORMANCE AUDIT REPORT INDIA EXTERNAL SECTOR AND INVESTMENT REGIME LIBERALIZATION (LOAN 3627-IN) June 28, 1996 Operations Evaluation Department This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Currency Equivalents (annual averages) Currency Rs/USS Official Unified Marketh Pnorto 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 January 1995 31.37 February 1995 31.38 March 1995 31.65 Source: IMF, International Finance Statistics (IFS), line "rf'; Reserve Bank of India. *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. Fiscal Year April I - March 31 Abbreviations and Acronyms CPI - Consumer Price Index FERA - Foreign Exchange Regulations Act GOI - Government of India IESIRL - India External Sector and Investment Regime Liberalization LERMS - Liberalized Exchange Rate Management System NFS - Non Factor Services OED - Operations Evaluation Department RBI - Reserve Bank of India SIL - Special Import License FOR OFFICIAL USE ONLY The World Bank Washington, D.C. 20433 U.S.A. Office of the Director-General Operations Evaluation June 28, 1996 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on India - External Sector and Investment Regime Liberalization (Loan 3627-IN) Attached is the Performance Audit Report (PAR) for the India, External Sector and Investment Regime Liberalization loan (Loan 3627-IN, approved in FY93 and closed in FY95) prepared by the Operations Evaluation Department. The objective of the US$300 million loan was to support the Government of India's ongoing reform of the country's trade regime and a liberalization of the investment licensing systems. This was a one-tranche operation, with all of the reform measures being undertaken prior to Board approval of the loan on June 24, 1993. This loan represented the third fast-disbursing operation in support of India's structural adjustment efforts, following a SAL (US$500 million approved in December 1991) and an IDA Credit supporting the Government's social safety net program (US$500 million approved in December 1992). The primary objective of increasing external and domestic competition and dismantling the country's pervasive system of economic controls and excessive trade protection was achieved. India's stabilization and structural reform program, initiated in July 1991, has been sustained over the past four years, with significant improvements in all macroeconomic indicators. Foreign reserves have increased dramatically (to a level over twice that projected in the President's Memorandum for the above operation), exports grew by 20 percent in dollar terms from July 1993 to June 1994, foreign investment inflows have improved and domestic and external confidence have been restored. Most importantly, despite considerable external debt service payments (estimated at US$19.5 billion) over the July 1994 to June 1997 period, projections of exceptional financing needs have been scaled downwards significantly. The outcome of the project is rated as highly satisfactory and its sustainability as likely. The project had no institutional development objectives. Bank performance is rated as highly satisfactory. There are a number of key lessons to be drawn from this project. First, a strong government commitment to the adjustment program over a sustained period contributed substantially to this operation's success. Second, given this commitment, and a demonstrated track record of policy reform, a one-tranche operation was warranted in support of the ongoing reform process. Third, detailed and comprehensive sector work was undertaken prior to, and during the reform process, which contributed greatly to the Government's and the Bank's understanding of the reform priorities and their implementation timing. Fourth, the sequencing of trade reform measures is a critical element in ensuri uccess. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. FOR OFFICIAL USE ONLY Contents Preface.............................................................3 Basic Date Sheet......................................................5 Evaluation Summary..................................................7 1. Background ........................................... ......13 2. Objectives and Design of the IESIRL ......................... ..........15 3. Implementation and Outcome .................................... .....19 4. Overall Assessment ....................... ................. 24 5. Project Sustainability ...............................................25 6. Lessons From The Project ...........................................26 Tables 1.1 Selected Indicators Prior to the Loan ...................................14 2.1 Tariff Structure in India - 1990-96 .....................................18 3.1 Economic Indicators Following the Loan................................ 20 3.2 Protection Rates....................................... ......22 3.3 International Comparisons of Effective Protection Rates ........ ... ...............22 Appendix I Comments from the Borrower ............................................27 This report was prepared by Roger Robinson (Task Manager) who audited the project in November 1995. Eneshi Irene K. Davis provided administrative assistance. The report was issued by the Country Policy, Industry and Finance Division, Manuel Pefialver, Chief, of the Operations Evaluation Department, Francisco Aguirre-Sacasa, Director. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization. 3 Preface 1. This is the Performance Audit Report (PAR) on the India External Sector and Investment Regime Liberalization Loan (Loan 3627-IN) for an amount of US$300 million. The loan was approved on June 1, 1993, and closed on December 31, 1994. 2. The PAR is based on the Implementation Completion Report (ICR) prepared by the South Asia Regional Office and issued in August 1995, the President's Report, the legal documents, a summary of the Board discussions, project files, related economic and sector work and discussions with Bank staff. The PAR extended the analysis in the ICR and it provided an insight into the Government of India's ongoing reform agenda and the economic results that flowed from the trade and investment reforms supported by this operation. There were no differences between the PAR and the PCR in terms of project ratings. 3. An OED mission visited India in November 1995, and discussed the effectiveness of the Bank's assistance through this project with relevant public sector officials, members of the banking community and some private sector trade organizations. Their kind cooperation and assistance in the preparation of this report is gratefully acknowledged. 4. The draft PAR was sent to the Borrowers for comments. Comments received from the Borrower are attached as Appendix 1. 5 Basic Data Sheet EXTERNAL SECTOR AND INVESTMENT REGIME LIBERALIZATION (LOAN 3627-IN) Key Project Data (amounts in US$ million) Appraisal Actual or Actual as % of estimate current estimate appraisal estimate Total project costs 300.0 300.0 100.0 Loan amount 300.0 300.0 100.0 Cofinancing - - - Cancellation - - Date physical components completed 12/31/94 12/31/94 Economic rate of return N/A N/A N/A Institutional performance Cumulative Estimated and Actual Disbursements FY93 FY94 Appraisal estimate (US$M) NA 300 Actual (US$M) 58.6 300 Actual as % of appraisal NA 100 Date of final disbursement: January 14, 1994 Project Dates Original Actual Initiating memorandum 03/08/93 03/08/93 Negotiations 05/28/93 05/28/93 Letters of Development Policy 04/30/93 04/30/93 Board approval 06/01/93 06/01/93 Signing 06/24/93 06/24/93 Effectiveness 09/22/93 06/25/93 Closing date 12/31/93 12/31/94 6 Staff Inputs (staff weeks) Total Preappraisal 126.6 Appraisal 51.3 Negotiations 0.6 Supervision 4.3 Other 1.0 Total 183.8 Mission Data Date No. of Staff days Specializations Performance Rating Types of (month/year) persons infield represented rating trend problems Identification/ 01/93 4 10 Trade, Preparation Macro, Legal Appraisal 04/93 9 15 Trade, Macro, Legal Supervision Completion Related Bank Loans/Credits PRECEDING OPERATIONS Operation Loan/Credit no. Amount Board date (US$ million) Structural Adjustment Loan/Credit Ln. 3421-IN, 500 12/91 Cr. 2316/0-IN, Cr. 2316/1-IN Social Safety Net Credit Cr. 2448-IN 500 12/92 7 Evaluation Summary Background 1. Throughout the sixties and seventies, India made steady , but modest, progress toward establishing a diversified economic base, improving food security and bringing about a reduction in absolute poverty. The economic momentum accelerated in the eighties, with average annual growth of over 6 percent per annum. This improved economic performance was driven in part by a gradual relaxation of regulations on investment and technology imports, but also by a rapid increase in public spending. By FY1990-91, the Central Government fiscal deficit had reached almost 9 percent of GDP, and the improved economic performance proved unsustainable due to the rising internal and external imbalances. 2. The inefficiency of resource allocation caused by the Government's pervasive system of domestic controls, was further aggravated by increases in the already high trade tariff levels that occurred during the 1980s. This widened the imbalance between the domestic price structure and that of the rest of the world. India's trade regime, by 1990, had evolved into a highly restrictive , discretionary and complex system, and Indian industry enjoyed very high and extremely variable levels of protection from international competition. In 1988 for example, the average nominal tariff was 141.2 percent, the trade weighted average was 85.5 percent and the average total collection rate was 61.9 percent. 3. Therefore, as a result of the increasing import restrictions in the 1980s, and the expansion of domestic demand fueled by the growing public sector deficits, the export orientation of firms in India declined in the face of the growth and profitability of the domestic market. It is not surprising that in a decade of significant growth in world trade, India's share in world markets declined. 4. The crisis came in July 1991. Inflation was running at an annual rate of 17 percent, international reserves had fallen to a level equivalent to two weeks of imports and the country was on the verge of default in its payment obligations on its external debt. The Government launched an immediate stabilization and structural adjustment program, with assistance from the IMF, World Bank and other multilateral and bilateral donors. The immediate reform effort focussed upon demand management and monetary stabilization. Fiscal adjustment, contractionary monetary policies and a flexible exchange rate policy were the key elements in the Government's economic program. In addition, a structural reform program was initiated focussing on trade, investment licensing, the financial sector, taxation and the public enterprises. 5. By the end of the Government's FY1992-93 (March 1993), the results were encouraging. The fiscal deficit had declined to 5.7 percent of GDP, inflation was below 10 percent and foreign reserves had increased to about 3.5 months import equivalent. Export performance however was less satisfactory, being static in nominal terms, but declining in real terms. The main cause was the collapse in exports to the former Soviet Union, but the emergency import restrictions imposed in FY1991-92 also deprived exporters of vitally needed imported inputs. 6. Thus, at the start of the third year of reform, India's balance of payments situation remained fragile and long term sustainability had not been achieved. The trade regime, while in the 8 process of reform, was still highly protectionist, and much more needed to be done. Furthermore, the overall regulatory and investment administration systems required further liberalization. Initial stabilization had been achieved, but pervasive structural reforms were still necessary if India was to realize its full growth potential. Objectives and Design of the Operation. 7. The fundamental objective of the India External Sector and Investment Regime Liberalization Loan (IESIRL) was to support the momentum of the Government's reform efforts undertaken in the previous two years, and to expand it in the areas of internal and external deregulation. Prior to this operation, the World Bank supported India's stabilization and adjustment efforts with a Structural Adjustment Loan/Credit for US$500 million (approved in December 1991), and a Social Safety Net Adjustment Program Credit for US$500 million (approved in December 1992). 8. The policy dialogue and specific objectives of the IESIRL, to support further trade and investment liberalization, focussed on four key areas. These are discussed below. 9. Foreign Investment and Investment Deregulation: The investment regime depended upon government licenses, with the result that foreign investment levels in India were well below those achieved in other developing countries. Foreign investors were further discouraged by the restrictions of the Foreign Exchange Regulations Act (1973), (FERA). This Act prevented companies with more than 40 percent of foreign equity from borrowing funds or raising deposits in India, from taking over any business interest from an Indian resident, from acquiring or disposing of any physical assets (including land) within India, from appointing managers and technicians and from using their trade marks without central bank clearance. 10. At the start of the reform effort in mid-1991, the Government took a number of important measures to liberalize the foreign and domestic investment climate. A New Industrial Policy was promulgated that reduced the number of sectors exclusively reserved for public sector investment from seventeen to eight, abolished the requirement for prior government approval for domestic investments except for eighteen so-called "sensitive" industries which accounted for about 20 percent of manufacturing value added, and granted automatic approval for new foreign investment up to 51 percent of equity in thirty four sub-sectors accounting for about 50 percent of manufacturing value added. 11. A very significant step took place in January 1993 with amendments to the FERA. These amendments removed all the restrictions cited above in paragraph 9. With the exception of restrictions on acquisition of enterprises in the agricultural sector, FERA companies (regardless of the proportion of foreign equity participation) were now treated on a par with domestic investors, and are permitted to remit dividends abroad without limitations or restrictions. 12. Finally, in March 1993, the Government introduced a new National Mining Policy which removed all mining products (except hydrocarbons, uranium and coal) from public sector reservation, with foreign equity up to 50 percent permitted. 13. These reforms proceeded over the two years prior to the loan, and at the time of Board presentation it was estimated that less than 15 percent of domestic value added in manufacturing, mostly in agro-industry, was still subject to licensing requirements. Furthermore the Government 9 stated its intent to proceed progressively in removing the licensing requirements for agro-industry as part of an agricultural reform agenda. 14. Exchange Rate Policy: Prior to July 1991, the exchange value of the Indian rupee was adjusted periodically by the Reserve Bank of India. In July 1991 the rupee was devalued by 22 percent. In February 1992, all emergency foreign controls that had been introduced in mid-1991 were removed and a Liberalized Exchange Rate Management System (LERMS) was introduced establishing a foreign exchange market. This was effectively a dual rate system, but the Government announced its intent to unify the rate over a two or three year period. This was achieved faster than expected, and in February 1993 a single exchange rate was introduced with the rate determined by the market. With some minor exceptions all current account transactions were permitted without prior approval. In August 1994 the rupee was made fully convertible for all current account transactions, and India now operates under Article VIII of the IMF's Articles of Agreement. 15. Tariff Reductions: In June 1991, India's tariffs were among the highest in the developing world. In mid 1991, the Government embarked upon a systematic tariff reform agenda. Tariffs were progressively reduced every year thereafter. Thus the overall import weighted tariff declined from 77 percent prior to the reform program to 41 percent prior to presentation of the IESIRL to the Board in June 1993. Furthermore the Government of India stated its intent to continue further over subsequent years. 16. Liberalization of Consumer Good Imports: Prior to the structural reform program, all consumer good imports were subject to licensing. It was an objective of the IESIRL to initiate a gradual and progressive reduction in the degree of effective protection granted to consumer goods industries in India. In October 1992 a Special Import License (SIL) scheme was introduced. These SILs granted to exporters the right to import a specified list of consumer goods, as a share of their export earnings. These rights were tradable. Further measures were taken in February 1993 which expanded the range of permissible consumer goods, and raised the entitlement, and the Government announced its intent to eliminate all restrictions on consumer good imports by March 1997. 17. The IESIRL was designed to have a one tranche disbursement. Given the tariff reduction element in the operation's objectives, it was felt that a one tranche mechanism was the most appropriate given that tax adjustments had to be submitted for Parliamentary approval in the normal annual budget cycle. It was recognized that a disbursement profile such as this carries the risk that the reform momentum will not be maintained. But, given the sustained reforms undertaken since July 1991, together with a well articulated agenda of medium term objectives announced by the Government, the Bank felt that a strong commitment by the Government of India had been demonstrated. Implementation and Outcome. 18. The IESIRL was approved by the Board on June 24,1993. The loan was fully disbursed and closed on schedule in December 1994. Cofinancing of US$250 million was provided by the Export-Import Bank of Japan in September 1993. By definition the loan's objectives were achieved at Board presentation, given the one tranche nature of the adjustment loan and the policy measures taken prior to the presentation. Besides an ongoing policy dialogue, implementation 10 focussed solely on the loan covenants related to procurement, record keeping and auditing, all of which were fulfilled completely. 19. Despite the one-tranche nature of the loan, it is appropriate to assess the economic outcome of the reforms undertaken. And, more critically, an assessment must be made of the achievements and sustainability of the ongoing reform effort that was initially supported by the project. 20. The economy has responded well to the stabilization and structural reform agenda. GDP growth has been steadily increasing since the stagnation in FY1991-92, reaching an estimated 6.0 percent in FY1995-96. This growth has been broad based, but the industrial growth has been particularly impressive with growth rates of 6.1 and 8.5 percent in FY1993-94 and FY1994-95 respectively, and reaching over 13 percent in the first six months ofFY1995-96. Employment creation has accelerated between 1992 and 1994 at a rate twice as fast as the period 1985 to 1992. 21. The improvement in the balance of payments has also been impressive. Exports have grown by over 20 percent since FY1992-93, and the share of exports and imports in GDP has been steadily rising, suggesting the economy is becoming more open. Foreign capital inflows have also recovered very well, reaching US$4.9 billion in FY1994-95, from a level of US$200 million in FYI990-91. The improving trade balance and increased capital inflows have brought about an improvement in the current account of the balance of payments, with a deficit of 0.4 percent of GDP in FY1994-95, compared to a deficit of 3.4 percent of GDP in FY1990-91. Foreign reserves have improved to an equivalent 8.6 months of imports by end March 1995. As a result of these developments, India's needs for exceptional balance of payments financing have declined dramatically. 22. The reform momentum was maintained following this operation. The reduction and rationalization of tariffs was continued in the Budgets of FYI 994-95 and FY1995-96. As a result of these measures, the average import weighted tariff has fallen to 27 percent from the 41 percent prevailing when this operation was presented to the Board. There has been a sustained and substantial reduction in the degree of protection of the Indian economy over the past four years. While still high by international standards, significant progress has been made. Furthermore, as subsequent Bank sector work has revealed, many Indian industries are actually more competitive than the effective and nominal rates of protection would suggest. There is extensive tariff redundancy across a wide range of Indian products, suggesting that tariff reductions can be even bolder and speedier in the future. 23. The Government of India has continued to liberalize consumer good imports, albeit at a rather slow pace. In 1994 and 1995, the list of consumer good items eligible to be imported using the SILs has been progressively expanded to now cover 75 items. Furthermore in December 1994, the Government of India reached an agreement on market access in textiles with the European Union and the United States. These agreements involve the phased liberalization of India's tariffs on certain items and a phased opening of India's market for imported textile products. 24. The Government of India has also continued to liberalize the investment regime. In January 1994, the Mines and Minerals (Regulation and Development) Act, 1957 was amended in line with the new National Mineral Policy announced in March 1993. This has allowed the private sector to participate in the mining sector. In February 1994, the Air Corporation Act, 1953 was repealed allowing private carriers to compete with the public ones. In May 1994, private 11 investment (including foreign investment up to 49 percent of equity) was allowed in the provision of basic telecommunication services, and in October 1994, private companies received licenses to operate cellular phones in main cities. In the banking sector, 10 new banks were granted licenses, including three of foreign origin. 25. Despite the reforms that have occurred in the investment environment undertaken by the Central Government, there remains an administrative clearance process at the State level. The States have been slower in adopting the bold reform initiatives of the Central Government, with the result that the overall regulatory environment is not as transparent nor as predictable as in many other Asian countries. There are signs however that the approach of the State governments is changing, and they are recognizing that they are in competition with each other to attract investment. As such a variety of States have instituted measures to be more facilitative, and this augurs well for the future. Overall Assessment. 26. This was a good project that supported a sustained reform of India's trade regime and its investment environment. As such the project's outcome has been rated as highly satisfactory. The one tranche nature of the operation was appropriate, and the reform momentum continued after loan closing. The pace of trade reform for consumer goods and agricultural products has been somewhat slow, and perhaps could have proceeded more expeditiously. However, as with all adjustment operations, the extent and pace of reform is a fine balance of many economic, social and political factors. Given the uncertainties in many sections of Indian society in late 1992 and early 1993, the cautiousness displayed by the Government of India in the liberalization of these two sectors may be understandable. The fact that with hindsight, this judgement proved too cautious should not detract from the very comprehensive reform agenda supported by this operation. 27. There were no institutional development objectives with this loan, and the institutional development impact is rated as negligible. Bank and Borrower performance are rated as highly satisfactory. One aspect not discussed in the ICR was the role of Economic and Sector Work (ESW) in furthering the policy dialogue and in creating a very firm foundation for the structural reform agenda that the Government adopted from mid 1991. A very comprehensive ESW program was undertaken in India from the mid eighties which encompassed the trade regime, the regulatory environment, the financial sector, non debt capital flows, small scale industry, public enterprises and all the sectors in varying degrees of complexity. All this work was available to the Government of India at the time it formulated its reform program. This undoubtedly contributed to the success of this project and the earlier adjustment operations. Project Sustainability. 28. The reform agenda in trade and investment regulation has continued after the loan closing. Furthermore the Government of India has publicly announced on a regular basis its intent to continue to liberalize and make more open the Indian economy. As such the sustainability is rated as likely. There is one caveat however. The pace of trade reform in India may be constrained by the high reliance of the Government on customs duties as a source of fiscal revenues. Further tariff reductions will have a fiscal cost, and while progress in improving fiscal performance has been made, the public sectors savings performance is still one of the worst in Asia. The overall fiscal deficit (at an estimate of 5.9 percent of GDP in FY 1995-96) still remains too high. 12 29. Given the high fiscal cost of trade reforms and the continued need to reduce fiscal imbalances, a comprehensive reform of the tax system to generate alternative sources of revenues will be necessary for trade reforms to continue expeditiously. The Government recognizes this and has embarked upon a tax reform effort. Reforms have occurred in the excise tax and value added tax systems and attempts are being made to improve compliance. Success in this fiscal adjustment effort will be a crucial prerequisite to maintain the trade reform momentum and sustain the progress achieved. Lessons From the Project. 30. There are a number of important lessons from this project. They are discussed below. 31. Government Ownership and Commitment: The experience with IESIRL reconfirms the well established finding that, for any adjustment operation to be successful, the government must be fully committed to a reform agenda that it considers its own. This requires a consensus building exercise by the government and solid adherence to a pre-announced set of quantifiable objectives and reform measures. 32. Trade Reform Sequencing: Experience with many countries around the world, and this operation is no exception, suggests that for a trade reform program to be successful the sequencing of the reform measures is crucial. Priority must be given to the removal of QRs and non-tariff barriers. Throughout the process the real exchange rate must remain competitive, with prudent macroeconomic policies. Tariffs must be progressively reduced, in accordance with a well articulated pre-announced schedule. Finally, any significant deviation from this pre-announced schedule will rapidly destroy the government's credibility, and thereby discourage producers from making the adjustments necessary to become more efficient and irternationally competitive. 33. One Tranche Disbursement: A one tranche disbursement may be appropriate to support an ongoing reform effort, provided the government in question has a clear commitment to reform in the medium term, and has already established a track record in implementing this reform agenda. 34. Economic and Sector Work: Good quality and extensive ESW is an essential prerequisite to ensure successful adjustment operations. ESW cannot guarantee success, but the lack of it adds to the risk that governments lack a full understanding of the policy framework, with the result that commitment to the reform agenda is undermined. 35. Macroeconomic Stabilization and Overall Structural Reform: A sector operation such as this must proceed in the context of a much wider, ongoing stabilization and structural reform agenda. The trade reforms to date in India are significant, but further needed progress will depend crucially on reforms in the tax system and continued determined fiscal adjustment. 13 1. Background 1.1 Throughout the sixties and seventies India made steady, but modest, progress toward establishing a diversified economic base, improving food security and bringing about a reduction in absolute poverty. Average annual growth of GDP ranged between 2.5 to 3.0 percent, and gross domestic investment had an average annual growth of about 4 percent. The economic momentum accelerated in the eighties. Growth increased to an annual average of over 6 percent and gross domestic investment reached an annual average of nearly 8 percent in the latter part of the decade. This improved economic performance was driven in part by a gradual relaxation of regulations on investment and technology imports, but also by rapid increases in public spending. By FY1990- 911, the Central Government fiscal deficit had reached almost 9 percent of GDP compared to about 6 percent five years earlier. 1.2 This improved performance proved to be unsustainable with rising internal and external imbalances. While some progress was made in reducing the burden of domestic regulation, this was insufficient to attract direct foreign investment or to allow domestic producers to respond rapidly to the depreciation (25 percent decline in the Real Effective Exchange Rate (REER) from 1984 to 1989). The inefficiency of resource allocation caused by the Government's system of domestic controls, was further aggravated by increases in the already high trade tariff levels that occurred during the 1980s. This widened the imbalance of the domestic price structure from the rest of the world. Concessions and special schemes to counteract the negative impact of these tariff measures only served to increase the complexity and reduce the transparency of one of the world's most complex trade regimes. 1.3 India's trade regime, by 1990, had evolved into a highly restrictive, discretionary and 2 complex system . Through a combination of high nominal tariffs, quantitative restrictions on imports, special exemptions and compensatory mechanisms, Indian industry enjoyed very high and extremely variable levels of protection from international competition. In 1988, the average nominal tariff was 141.2 percent, the trade weighted average was 85.5 percent and the average 3 total collection rate was 61.9 percent . 1.4 Therefore, as a result of the increasing import restrictions in the 1980s, and the expansion of domestic demand fueled by the growing public sector deficits, the export orientation of firms in India declined in the face of the growth and profitability of the domestic market. It is not surprising that in a decade of significant growth in world trade, India's share in world markets declined. Furthermore, while export growth did accelerate in the latter part of the 1980s as a result of the real devaluation of the rupee and buoyant world demand, this was mostly in well established traditional products ( gems and jewelry, garments, tea, carpets, spices, marine products and some raw material based products). The share of non traditional manufactured exports in the total declined from 33.3 percent in 1970-71 to 26.0 percent in 1986-87. 1 The Indian fiscal year runs from April 1 to March 31. 2 See World Bank Report No. 8998-IN: India: Strateev for Trade Reform, November, 1990. For comparison, in the same year, the average total collection rates for some countries are as follows: Pakistan (24.7 percent), Indonesia (7.0 percent), Turkey (12.5 percent), Brazil (8.7 percent) and Mexico (8.3 percent). 14 1.5 The crisis came in July 1991, just one month after the present government took office. By mid 1991, inflation was running at an annual rate of nearly 17 percent, well above India's historically low inflation rates, and if uncorrected, the Central Government's fiscal deficit would have exceeded 10 percent of GDP in 1991-92. International reserves had fallen to a level equivalent to two weeks of imports and a lack of confidence in overall policy management closed access to external finance from commercial sources. The country was on the verge of default in its payment obligations on its external debt. Table 1.1 Selected Indicators Prior to the Loan (% of GDP at market prices unless otherwise stated) 1980-81 1985-86 1989-90 1990-91 1991-92 1992-93 National Accounts Domestic Savings 17.4 18.8 20.1 21.5 20.0 20.7 Fixed Investment 19.3 18.7 20.5 21.2 20.1 19.7 o/w Public Sector 8.6 9.7 8.6 8.8 8.7 7.7 Government Accounts Fiscal Deficit 6.2 8.3 7.8 8.4 5.9 5.7 Revenues 8.8 11.4 10.3 11.2 10.8 Expenditures 16.2 20.3 18.7 17.1 16.5 External Accounts Current Account Balance -1.7 -2.8 -2.7 -3.4 -0.7 -1.6 Exports (Goods + NFS) 6.5 5.8 6.4 6.8 7.5 9.7 Imports (Goods + NFS) 10.1 10.3 9.8 9.7 8.3 11.1 Foreign Reserves (months of 5.2 4.6 2.0 1.0 3.3 3.5 Imports) External Debt 16.1 19.1 26.9 27.5 35.9 37.1 Debt Service (% Gross 9.2 22.7 27.6 30.3 28.2 28.1 Current Receipts) Inflation (CPI) (%) 6.8 7.4 10.3 13.7 10.9 Memo Item 75-80 80-85 85-90 90-92 GDP Growth (period annual 3.0 5.3 6.7 4.8 average %) Source: World Bank data. 15 1.6 The Government launched an immediate stabilization and structural adjustment program. The IMF, World Bank, the Asian Development Bank, and other multilaterals and bilateral donors, particularly Japan, provided strong support to the Government's economic program and helped India meet its exceptional financing requirements of US$2.5 billion a year in FY1991-92 and FY1992-93. The immediate reform effort focused upon demand management and monetary stabilization. Fiscal adjustment, contractionary monetary policies and a flexible exchange rate 4 policy were the key elements in the Government's economic program . In addition, a structural reform program was initiated focusing on trade, investment licensing, the financial sector, taxation and the public enterprises. Tariffs were lowered, investment licensing progressively liberalized and the balance of payments management became more price based with the removal of licensing requirements for capital and intermediate good imports. 1.7 By the end of 1992-93 (March 1993), the results were encouraging. The fiscal deficit declined to 5.7 percent, inflation was below 10 percent and foreign reserves increased to US$6.7 billion (about 3.5 months import equivalent). As might be expected given the emergency import restrictions imposed in 1991, and the contractionary monetary policies followed, GDP growth was modest in FY1991-92 (1.2 percent) but this rebounded to 4.0 percent in the following year. Export performance however was less satisfactory, being static in nominal terms, but declining in real terms. The main cause for this was the collapse in exports to the former Soviet Union (from US$3.0 billion in FY1989-90 to US$600 million in FY1992-93), but the emergency import restrictions also deprived exporters of vitally needed imported inputs. 1.8 Thus, at the start of the third year of reform, India's balance of payments situation remained fragile and long term sustainability had not been achieved. The trade regime, while in the process of reform, was still highly protectionist, and more needed to be done. Furthermore, the overall regulatory and investment administration systems required further liberalization if the important contribution that direct foreign investment could make to India's development was to be realized. Finally, while progress had been made to reduce the fiscal imbalance, much still needed to be done if the deficit target of 3.0 percent of GDP was to be realized in FY1995-96. This would require adjustments to both expenditures and the tax system. Initial stabilization had been achieved, but pervasive structural reforms were still necessary if India was to realize its full growth potential. 2. Objectives and Design of the IESIRL 2.1 The India External Sector and Investment Regime Liberalization operation was approved by the Board on June 24,1993. The loan was fully disbursed and closed on schedule in December, 1994. Cofinancing of US$250 million was provided by the Export-Import Bank of Japan in September 1993. Prior to this operation, the World Bank supported India's stabilization and adjustment efforts started in July 1991, with a Structural Adjustment Loan/Credit for US$500 million approved by the Board in December 1991, and a Social Safety Net Adjustment Program Credit for US$500 million approved by the Board in December, 1992. The SAL's objectives were to support the Government's efforts in liberalizing the industrial and trade regimes, reforming the financial sector and restructuring public enterprises. The SAL objectives were generally met in all 4 See World Bank, Country Economic Memorandum, Report No. 10489-IN, India: Stabilizing and Reforming the Economy, May 1992, and the Country Assistance Strategy presented to the Board in December, 1992. 16 four reform areas, and given the delicensing of imports of intermediate and capital goods and the 5 introduction of a free foreign exchange market in March 1992, some targets were exceeded 2.2 The IESIRL was unusual in being a one-tranche operation, with the immediate loan objectives being achieved and Government reform actions taken prior to Board presentation. The fundamental objective of the loan was to support the momentum of the Government's reform efforts undertaken in the previous two years. Discussions with the authorities commenced shortly after the second tranche review of the December 1991 SAL, in June 1992. 2.3 Despite the progress made in bringing about a restoration of monetary stability and investor confidence in the policy framework, and the improvement in the foreign reserve position, as noted in paragraph 1.8, management of the balance of payments was still a difficult and challenging task. In the four years from March 1993, India was required to repay US$23 billion of its US$76 billion external debt. Financing the current account deficit and debt repayments required about US$8 billion in gross inflows in FY1993-94, and about US$10 billion in the subsequent three years. It was estimated that three quarters of this requirement could be met through disbursements on existing and expected commitments from bilateral and multilateral sources and private creditors. There remained exceptional financing needs of about US$1.8 billion in FY1993-94 and between US$2 and US$2.5 billion in the subsequent three years. Hence there was a clear need for Bank balance of payments support. 2.4 The policy dialogue and specific objectives of the loan were to support further trade and investment liberalization and focused on four key areas. These included: * Amendments to the Foreign Exchange Regulations Act (FERA) and further investment deregulation, * Reunification of the exchange rate, * Further tariff reductions, and * Further measures to liberalize consumer good imports. 2.5 Foreign Investment and Further Investment Deregulation: The investment regime depended upon government licenses, and resulted in foreign investment levels well below those achieved in other developing countries. Foreign investors were further discouraged by the restrictions in the FERA of 1973. This Act prevented companies with more than 40 percent of foreign equity from borrowing funds or raising deposits in India, from taking over any business interest from an Indian resident, from acquiring or disposing of any physical assets (including land) within India, from appointing managers and technicians and from using their trade marks without central bank clearance. Indicative of the restrictiveness of the foreign investment regime, in early 1993, there were only 80 firms in India with more than 40 percent of foreign equity. 2.6 The present government took a number of important measures to liberalize the domestic and foreign investment climate. In July 1991 a New Industrial Policy (NIP) was promulgated that reduced the number of sectors exclusively reserved for public sector investment from seventeen to eight, abolished the requirement for prior government approval for domestic investments except for eighteen "sensitive industries accounting for about 20 percent of manufacturing value added, 5 For full details see the Performance Audit Report: India - Structural Adjustment Loan/Credit (Loan 3421-IN; Credits 2316-0-IN and 2316-1-IN) which is forthcoming. 17 and granted automatic approval for new foreign investments up to 51 percent equity in thirty four sectors (about 50 percent of manufacturing value added). A very significant step took place in January 1993 with amendments to the FERA Act. These amendments removed all the restrictions cited above. With the exception of restrictions on acquisition of enterprises in the agricultural and plantation sectors, FERA companies (regardless of the proportion of foreign equity participation) are now treated at a par with domestic investors, and are permitted to remit dividends abroad without limitations or restrictions. Those restrictions remaining relate only to capital movements in the capital account of the balance of payments. 2.7 Finally, in March 1993, the Government introduced a new National Mining Policy which removed all mining products (except hydrocarbons, uranium and coal) from public sector reservation. Foreign equity participation up to 50 percent was also permitted. Aside from the reserved mining sectors, only railways, uranium processing, coal extraction and defense industries remain under public sector reservation. In addition in April 1993, investment licensing restrictions and requirements were removed for leather, and household appliances, and in April 1994, these restrictions were removed for automobiles. 2.8 These reforms, which took place over the two years prior to the loan, were indeed significant. At the time the operation was presented to the Board, it was estimated that less than 15 percent of domestic value added in manufacturing, mostly in agro-industry, was still subject to licensing requirements. Furthermore the Government stated its policy intent to proceed progressively in removing the licensing requirements for agro-industry as part of an agricultural reform agenda. 2.9 Exchange Rate. Prior to July 1991, the exchange value of the Indian rupee was adjusted periodically by the Reserve Bank of India (RBI). In July 1991 the rupee was devalued by 22 percent, which together with tight monetary policies succeeded in stopping capital outflows and the run on reserves. Then, in February 1992, all emergency foreign exchange controls were removed and a Liberalized Exchange Rate Management System (LERMS) was introduced establishing a foreign exchange market. This was effectively a dual exchange rate system with foreign exchange being sold at the official rate for certain designated imports, foreign exchange for all other imports was available through an interbank market at a market rate. Forty percent of export receipts had to be surrendered at the official rate, the remainder could be sold at the market rate. 2.10 When this dual rate system was introduced the Government announced its intent to unify the rate gradually over a two or three year period. This was achieved faster than expected, and in March 1993 a single exchange rate was introduced with the rate determined by the market. Foreign exchange dealers are free to maintain balances in convertible currencies both domestically and abroad. With the exception of insurance purchased abroad, and imports still subject to license, all current account transactions are permitted without prior approval. Most capital account transactions still require approval. In August 1994 the rupee was made fully convertible for all current account transactions, and India now operates under Article VIII of the IMF's Articles of Agreement. 18 Table 2.1: Tariff Structure in India - 1990-96 (average %) Pre Reform Post Reform 1990-91 1992-93 1993-94 1994-95 1995-96 All Tradables Unweighted 128 94 71 53 42 Import Weighted 77 54 41 32 27 Manufacture Unweighted 130 98 73 55 NA Import Weighted 82 62 44 34 NA Consumer Goods Unweighted 142 92 76 59 43 Import Weighted 164 144 33 48 39 Intermediates Unweighted 133 104 77 59 45 Import Weighted 117 55 40 31 24 Capital Goods Unweighted 109 86 58 42 35 Import Weighted 97 76 50 38 30 Memo Item Collection Rates (%) 41.6 32.3 28.0 Source: World Bank Report No. 13169-IN: India - Issues in Trade Reform, August 1994, and World Bank Report No. 14402-IN: India - Country Economic Memorandum, May 1995. 2.11 TariffReductions: In June 1991, India's tariffs were among the highest in the developing world. And unlike many developing countries, these tariffs were not diluted by many exemptions, which resulted in very high collection rates (see Table 2.1). In a supplementary budget in July 1991, the Government embarked upon a systematic tariff reform agenda. The maximum tariff rate was reduced from 350 percent in FY1990-91, to 150 percent in FYI991-92, 110 percent in FY1992-93 and 85 percent in FY1993-94. The overall import weighted tariff declined from 77 percent prior to the reform program to 41 percent prior to presentation of the IESIRL to the Board in June 1993. Furthermore the Government of India stated its intent to continue further with a tariff reduction program over subsequent years. 2.12 Further Measures to Liberalize Consumer Good Imports: Licensing restrictions on imports under the structural adjustment program were liberalized in two phases. First during July to December 1991, items were shifted from more restrictive to less restrictive lists. Then, during 19 March to April 1992, the import licensing regime for capital goods and intermediates was essentially dismantled, with one so-called "negative" list of items still subject to licensing. For consumer goods, however, licensing requirements remained, and represented the most serious non- tariff restriction on imports into India. 2.13 It was an objective of the IESIRL, therefore, to initiate a gradual and progressive reduction in the degree of effective protection granted to consumer good industries in India. In October 1992, a limited liberalization of consumer good imports occurred with the introduction of a Special Import License (SIL) scheme. The SILs, granted to exporters as shares of their gross export earnings (ranging from 2 to 4 percent), were tradable and could be used to import a specified list of consumer goods. Additional measures were taken in February 1993, when the tariffs on consumer goods imported as personal luggage were lowered from 255 percent to 150 percent, and restriction on the resale of these items was abolished. The entitlement for issue of SILs has been raised to 4 to 11 percent of FOB value exports, and in March 1996, the coverage of items eligible for import against SILs has been expanded. Furthermore, the Government of India stated its intention to abolish import restrictions on consumer goods by the end of the Eighth Plan Period (1992-1997), with protection being provided solely by tariffs. 2.14 An unusual feature in the design of this operation was the one tranche disbursement profile. Given the tariff reduction element in the operation's objective, it was felt that a one tranche mechanism would be more suitable given that tax adjustments have to be submitted for Parliamentary approval in the normal annual budget cycle. Clearly a disbursement profile such as this carries certain risks with regard to ongoing reform commitment and overall sustainability of the reform effort. Given the bold and sustained reforms undertaken from July 1991, together with a well articulated agenda of medium term objectives, the Bank felt that a strong commitment by the Government of India had been demonstrated, and the one tranche approach was justified. 3. Implementation and Outcome 3.1 By definition, loan objectives were achieved at Board presentation, given the one tranche nature of the adjustment loan and the policy measures taken prior to the presentation. Implementation focused only on the loan agreement covenants related to procurement, record keeping and auditing, all of which were fulfilled completely. 3.2 In an evaluation of the outcome of this project, however, one must assess whether the much broader objective of supporting the Government of India's reform momentum and the structural adjustment inherent therein, was achieved. An assessment must be made of the overall economic impact, which responds with a lag, to changes in the policy environment and price incentive framework. Most critically, an assessment must be made of the ongoing reform effort that was initially supported by this project, and the previous adjustment operations. 3.3 The economy has responded well to the overall stabilization and structural reform programs, and the reforms supported under this operation. GDP growth has been steadily 20 increasing since the stagnation in FYI991-92, reaching an estimated 6 percent in FY1995-966. This GDP growth was broad based, but the industrial sector has been particularly impressive with growth rates of 6.1 and 8.5 percent in FY1993-94 and FY1994-95 respectively, and reaching over 13.0 percent in the first six months of FY1995-96. Inflation has been a source of concern, however, reaching an historical high of 13.7 percent in FY1991-92. But tight monetary policies, and progress in improving fiscal performance, have gradually borne fruit, with an estimated price rise of about 7 percent in FY1995-96. Employment creation has accelerated, increasing twice as fast between 1992 to 1994 than during the period 1985 to 1992, at a rate of 6 million new jobs a year In FY1994-95, employment growth was 7.8 million. This impact on employment is a very positive result and certainly refutes the detractors of trade reform in India, who felt that a significant reduction in protection would lead to massive job losses. Table 3.1: Economic Indicators Following the Loan (% of GDP at market prices unless otherwise stated). 1993-94 1994-95' 1995-962 National Accounts Domestic Savings 21.4 24.4 n.a. Fixed Investment 21.5 22.5 n.a. % Public Sector 8.4 8.7 n.a. Government Accounts (Central Gov't) Fiscal Deficit 7.5 6.3 5.9 Revenues (total revenue and grants) 9.9 10.5 10.8 Expenditures (total expend./net lending) 17.5 16.8 16.7 External Accounts Current Account Balance -0.3 -0.9 -1.6 Exports (Good + NFS) 11.3 11.3 12.5 Imports (Goods + NFS) 11.5 13.0 14.3 Foreign Reserves (months of imports of goods) 7.7 8.1 5.3 External Debt 36.1 32.9 29.7 Debt Service (% Gross Current Receipts) 25.6 25.3 24.4 Inflation (CPI) (%) 9.9 9.7 8.0 GDP Growth (%) 5.0 6.3 5.8 Estimates. Projection from CAS 96 up-date.. Sources. World Bank data Government of India Economic_Survey 1995-96; national accounts quick Estimates, 1994-95. Interim Budget Documents 1996-97. Other unofficial estimates in the Government of India suggested to the Audit mission that this was an underestimate, and that 7 to 8 percent, based upon certain indicators (e.g. power generation and port utilization) was more accurate. 21 3.4 The improvement in the balance of payments situation has been dramatic. Exports grew by 20 percent in FY1993-94, by over 16 percent in FY1994-95 and reached 27.9 percent in the period April to August 1995 over the same period in 1994. Furthermore, and perhaps most importantly, the share of exports and imports in GDP has been steadily rising and the apparent elasticities of both with respect to GDP have increased, suggesting the economy is gradually becoming more open. Foreign capital inflows have also recovered exceptionally well, reflecting the success of the Government's stabilization program and the credibility of its reform agenda. Foreign capital inflows reached US$4.9 billion in FY1994-95, of which US$1.3 billion was direct foreign investment, and US$3.6 billion was portfolio investment. From a level of USS200 million in FY1990-91, this is indeed a signal achievement. 3.5 The improving trade balance and increased foreign capital inflows, have brought about a major improvement in the current account of the balance of payments, with a deficit of 0.4 percent of GDP in FY1994-95, compared to a deficit of 3.4 percent of GDP in FYI990-91. There has been a concomitant improvement in the foreign reserve position which was equivalent to 8.6 months of imports by March 1995, compared to less than one month in mid-1991. As a result of these developments in India's external payments situation, the needs for exceptional balance of payments financing have declined dramatically. 3.6 The reform momentum was maintained following this operation. The reduction and rationalization of tariffs continued in the Budgets of FY1994-95 and FY1995-96. Tariff reductions occurred across all groups , but the cuts were larger on capital and intermediate goods. As a result of these measures the average import weighted tariff has fallen to 27 percent (see Table 2.1) from the 41 percent prevailing when this operation was presented to the Board. The highest import duty is now 50 percent. Furthermore, the latest round of tariff adjustments went some way toward removing anomalies in the duty structure such as the multiplicity of rates on the import of capital goods, and tariffs on imports of inputs for the capital goods industry higher than those for the final product. For example, import duties on general machinery, machine tools and instruments have been unified at 25 percent. 3.7 As the data shown in Tables 3.2 and 3.3 clearly indicates, there has been a sustained and substantial reduction in the degree of protection of the Indian economy over the past four years. While still high by international standards, significant progress has been made. Furthermore, as Bank sector work has revealed, many Indian industries are actually more competitive than the effective and nominal rates of protection would suggest. Nominal protection coefficients, collected at the firm level in 1993 and 1994, indicate there is extensive tariff redundancy, meaning that the protection granted by the nominal tariffs is higher than the differential between domestic and international prices. This tariff redundancy was found for a wide range of capital goods and intermediate products, and, surprisingly for many consumer goods which are the most highly protected category. This tariff redundancy reflects in part the use of high tariffs as a fiscal revenue source, but it also suggests that considerable room exists, particularly for consumer goods, for bolder and speedier tariff reductions. As discussed below (see para 5.2), the fiscal constraint is a major factor in influencing the Government's capacity and willingness to maintain the momentum of the trade liberalization agenda. 22 Table 3.2: Protection Rates (percent) 1990-91 1992-93 1993-94 1994-95 Effective Rate of Protection' Intermediate Goods 148.0 114.3 90.3 71.2 Capital Goods 87.1 69.5 45.5 38.4 Consumer Goods 191.8 124.6 97.2 81.0 Total Manufacturing 163.8 113.8 87.9 72.1 Nominal Rate of Protection' Intermediate Goods 124.8 99.9 77.0 54.5 Capital Goods 106.4 82.2 51.2 42.5 Consumer Goods 136.9 99.0 74.9 59.0 Total Manufacturing 129.1 97.0 73.1 55.4 The Nominal Rate of Protection is the premium paid domestically because of trade restrictions. It is calculated as the ratio of domestic price to international price at the country's border, expressed as a percentage. The Effective Rate of Protection is a measure of protection to net value added in the production of a particular good. This tends to be a better measure as it takes into account protection on traded inputs. It is calculated as a ratio of value added in domestic prices to value added in international prices, expressed as a percentage. Note: All figures are weighted based on value added weights of an input/output matrix for India. Source: World bank Report No. 13169, August 1994. Table 3.3: International Comparisons of Effective Protection Rates India Indonesia Mexico Philippines Thailand (1994) (1992) (1989) (1992) (1988) Effective Rates Agriculture 25 14 8 4 13 Mining 33 -1 11 5 N/A Manufacturing 72 52 23 32 42 Whole Economy 42 13 18 23 30 Note: The rates shown are weighted by Value Added. Source: World Bank Report No. 13169-IN, August 1994. 3.8 The Government of India has continued to liberalize consumer good imports, but the pace has been relatively slow, notwithstanding the aforementioned tariff reductions, and it appears that 23 this process could be accelerated. In March and July 1994, the list of consumer good items that could be imported by exporters using the SILs was expanded and the license values raised to 3 to 10 percent (compared to the previous 2 to 4 percent). In April 1995, further liberalization occurred with a further expansion of the list to 75 items. Furthermore, in December 1994, the Government of India reached agreement with the European Union and the United States on market access in textiles. These agreements involve the phased liberalization of India's market for imported textile products. As a first step, textiles and garments were placed on the list of items that can be imported with SILs. All these partial steps toward the elimination of non-tariff barriers to consumer good imports are welcome, however, the pace is modest. 3.9 One area of reform of the trade regime omitted in the IESIRL was the agricultural sector. With the exception of pulses, sugar and edible oils, all agricultural imports remain restricted. This means that over 80 percent of agricultural value added is covered by QRs. Removal of these import restrictions should have a limited impact on domestic agricultural prices, because domestic prices (with the exception of oilseeds) are all below international levels7. Given the large weight of agriculture in total tradable value-added (about 60 percent), the restrictions on agricultural imports means that the QR coverage of all tradables was still a very high 76 percent in 1994. 3.10 The agricultural sector and food self sufficiency policies in India are sensitive political issues, with their roots in the country's experiences with famine and severe shortages. Agricultural exports are also restricted, which, together with domestic market regulations, are designed to shelter the most vulnerable parts of the population from the higher prices that might result if free agricultural trade occurred. The argument is that, while rural wages would adjust to higher domestic agricultural commodity prices, this would occur with a lag, and the rural poor could be put at substantial risk. But this does not imply that the agricultural product trade regime should not be adjusted. Rather, it means that reform in this area need to occur in the context of broad agricultural sector reform, with specific safety net provisions to protect the more vulnerable groups affected during the transition. 3.11 In sum, the trade reform agenda has been maintained over an extended period (five years), with significant liberalization occurring. The economy's response to these reforms has been positive, with a substantial improvement in the external balance and improving competitiveness of Indian industry. The success of this effort is attributable, in part, to the manner and sequence of the trade regime liberalization. There has been a preannounced schedule, with early priority given to QRs and non-tariff barriers. At the same time, competitive real exchange rates have been maintained throughout the period and macroeconomic imbalances have been steadily reduced. Finally, measures were introduced to increase export incentives and assistance given to industry to adapt to the changing competitive environment as a result of the lower nominal tariff barriers. 3.12 The Government of India has also continued to liberalize the investment regime . In January 1994, the Mines and Minerals (Regulation and Development) Act, 1957 was amended in In FY1992-93, domestic prices were below international levels by about 40 percent for wheat, rice and pulses, 30 percent for cotton and 20 percent for maize. 8 A study undertaken by an independent international accounting firm, with offices in India, found "in terms of openness to foreign investment, the Indian policy environment is comparable to that of Korea, Taiwan and Indonesia. The Indian policy framework is more restrictive than that of Singapore and Thailand but compares favourably with that of Malaysia and China". Price Waterhouse, January 1993. 24 line with the new National Mineral Policy announced in March 1993. This allowed the private sector to participate in the mining sector and in March 1994, 13 proven coal mines were offered to private power and iron and steel companies. In February 1994, the Air Corporation Act of 1953 was repealed allowing private airlines to compete with public airlines. In May 1994, private investment (including foreign investment up to 49 percent of equity) was allowed in the provision of basic telecommunication services, and in October 1994, private companies received licenses to operate cellular services in four main cities. In the banking sector 10 new banks were granted licenses, including three of foreign origin. As a result of these reforms, and the earlier reforms undertaken prior to this operation, Direct Foreign Investment has increased from US$264 million in 1992 to US$902 million in the first eight months of 1995. 3.13 Despite the progress made in the investment environment in India, there remain considerable bureaucratic obstacles and constraints. The policy of the Central Government has changed, but there are still the requirements for clearances at the State level, as the States have certain jurisdictions over power, land, water, labor and environmental issues. In operational terms therefore, the regulatory environment is not as transparent and predictable as most developing countries in Asia. The point was made to OED staff during the Audit mission by several Government officials, that the regulatory difficulties encountered at the State level were often related to real infrastructure constraints, particularly power and water availability. It is also noteworthy that in 1995, the country's port systems were operating at 115 percent of rated capacity. Nevertheless, despite these possible infrastructure constraints, the States have been slower in adopting the bold reform initiatives of the Central Government. 3.14 The approach of the State governments may be slowly changing, however, and increasingly States are recognizing they are in competition with each other for investment. As a result they are attempting to reduce bureaucratic obstacles and be more facilitative. A number of States have instituted so called "single window" approval facilities (West Bengal and Haryana), adjusted land zoning regulations (Rajasthan), provided exemptions on State taxes for a stipulated period (Kerala) and been more pro-active in trying to solve investor problems (Orissa). These are all welcome signs and suggest that the investment regime liberalization process in India will gather further momentum. 4. Overall Assessment 4.1 This was a successful project, that supported a bold and sustained reform of India's trade regime and investment environment. As such the operation's outcome has been rated as highly satisfactory. The one tranche nature of the operation was appropriate, and the reform momentum continued after closing. There are two areas where reform of the trade regime has been slow; namely agricultural products and consumer goods. In the latter case particularly, the move toward tariffications and away from outright restriction could have proceeded more expeditiously, and the introduction of SILs is a short run palliative at best. To suggest that the design of the project, and the policy dialogue during its conception, could have sought a more robust reform of the trade regime affecting consumer goods does not detract from the highly satisfactory nature of the project. As with all adjustment operations, the extent and pace of reform is a fine balance of many economic, political and social factors. Given the uncertainties in many sections of Indian society in late 1992 and early 1993, the cautiousness with which the Government of India wished to proceed in the liberalization of trade in consumer goods may be understandable. The fact that this 25 judgement may have been too cautious should not detract from the very comprehensive reform agenda supported by this operation. 4.2 There were no institutional development objectives with this project, and the institutional development impact is rated as negligible. Bank and Borrower performance were rated as highly satisfactory. One element not adequately discussed in the ICR was the role of Economic and Sector Work (ESW) in furthering the policy dialogue and creating a very firm foundation for the structural reform agenda that the Government of India adopted from the second half of 1991 on. A very comprehensive ESW program was undertaken in India from the mid-eighties which encompassed the trade regime, the regulatory environment, the financial sector, non-debt capital flows, small scale industry, public enterprises and all the sectors in varying degrees of complexity. All this work was available to the Government of India at the time it formulated its reform agenda, and in some cases (the trade regime for example) the sector studies undertaken by the Bank represented the most comprehensive and detailed analysis ever undertaken on the topic in India. This undoubtedly contributed to the success of this project, and to the earlier adjustment operations. 5. Project Sustainability 5.1 As discussed above, the reform agenda in trade and the investment regulatory environment has continued following closure of the loan. Furthermore, the Government of India has publicly announced on a regular basis its intent to continue to liberalize and make more open the Indian economy. As such, the sustainability of this project is rated as likely. There is one caveat however. The pace of trade reform in India may be constrained by the high reliance of the Central Government on customs duties as a source of revenue. There is a significant fiscal cost to further trade reforms, and the Government of India, while making some progress in its fiscal reform efforts, needs to improve its public savings performance which is one of the worst in Asia. In 1990, the year prior to the reforms, customs revenues in India made up 37 percent of Central Government revenues and 4 percent of GDP. Customs revenues as a share of GDP more than doubled between the early 1970s and the late 1980s. This was among the highest such shares compared to other major developing countries. 5.2 Throughout the last five years, the Government of India has sought to reduce the fiscal imbalances, with some success. But the overhaul deficit (at an estimate of 5.5 percent of GDP in 1995-96) still remains unsustainably high. In part, this reflects the move toward market interest rates for government debt, a necessary structural reform, and the primary deficit (which excludes interest payments) has declined significantly from 4.3 percent of GDP in FY1990-91 to 1 percent of GDP in FY1995-96 (budget estimate). So fiscal adjustment has occurred, but given the urgent infrastructural and social development needs of the country, more will need to be done. 5.3 Given the high fiscal cost of trade reforms and the continued need to reduce fiscal imbalances, a comprehensive reform of the tax system to generate alternative sources of revenues will be necessary for trade reforms to continue expeditiously. The Government of India recognizes this and has embarked upon a tax reform effort. A major reform of excises was implemented to make the system more closely resemble a value added tax. And the coverage of the existing so- called modified value added tax (MODVAT) was extended. Most excise rates have been shifted to an ad-Valorem basis, which increases bouyancy, and the number of different rates has been 26 reduced. The latest FY1995-96 Budget has continued with these efforts to simplify the overall tax systems and improve compliance. Success in the fiscal adjustment effort will be a crucial prerequisite, if the trade reform momentum is to be maintained. 6. Lessons From The Project 6.1 There are a number of lessons that can be derived from this successful project. They are discussed below. 6.2 Government Ownership and Commitment: For any adjustment program to be successful, the government must be fully committed to a reform agenda that it considers its own. This requires a consensus building exercise by the government on its reform program and solid adherence to a preannounced set of quantifiable objectives and reform measures. 6.3 Trade Reform Sequencing: Experience with many countries around the world, and with this operation and the Government of India's trade reform agenda, suggest that for a trade reform program to be successful the sequencing of the reform measures is crucial. Priority must be given to the removal of QRs and non-tariff barriers. Throughout the process the real exchange rate must remain competitive, with prudent macroeconomic policies. Tariffs must be progressively reduced, in accordance with a well articulated, preannounced schedule. Finally, any significant deviation from the preannounced schedule, will rapidly destroy perceptions of the credibility of the government's reform agenda, and thereby discourage producers from making the adjustments necessary to become more efficient and internationally competitive. 6.4 One Tranche Disbursement: A one tranche disbursement adjustment operation may be appropriate to support an ongoing reform effort, provided the government in question has a clear commitment to reform in the medium term, and already has an established track record in implementing this reform agenda. 6.5 Economic and Sector Work: Good quality and extensive ESW is an essential prerequisite to ensure successful adjustment operations. ESW cannot guarantee success, but the lack of it adds to the risk that governments lack a full understanding of the policy framework, and the scope of needed adjustment, with the result that commitment to the reform agenda is undermined. In the case of trade reform in India, the Government was in receipt of a very detailed trade regime sector study a full eighteen months prior to announcing a trade reform agenda. This undoubtedly helped in forming the necessary consensus across all parts of the political and business spectrum, and thereby increased the probability of sustainability of the reform program. 6.6 Macroeconomic Stabilization and Overall Structural Reform: A sector adjustment operation such as this must proceed in the context of a much wider, ongoing stabilization and structural reform agenda. Trade reform in India to date is significant, but further needed progress will depend on reforms in the tax system and continued determined fiscal adjustment. Furthermore, steps to restructure and improve the efficiency of public enterprises in India should be accelerated, if they are not to present a politically sensitive bottleneck to bringing the Indian economy further into the world economy. 27 Appendix 1 D.O. No. 1297 (FB VI) 96 BR. Khurana Government of India Under Secretary (FB) Ministry of Finance Tel. No. 3012836 Department of Economic Affairs New Delhi May 7, 1996 Dear Mr. Landau, 1. Please refer to your letter dated April 4, 1996, regarding the draft Performance Audit Report in respect of External Sector and Investment Regime Liberalization (Loan No. 3627-IN). 2. It is observed that the draft PAR gives inadequate coverage of the progress made in the area of liberalization of consumer goods imports. As such, the following may be added at the end of paragraph 16: "Since the introduction of the Special Import Licenses (SIL) scheme in October 1992, there has been expansion of the list of consumer goods importable under SILs. The entitlement for issue of SILs has also been raised to 4-11% of fob value exports from 2-4% earlier. In the latest amendments to EXIM Policy, 1992-97, notified in March 1996, the coverage of items eligible for import against SILs has been expanded. At the same time, 7 items have been transferred from SIL list to the free list, of which 4 tariff lines are consumer goods. There has been further policy developments in this area since March 31, 1995. Any person can import parts or components of consumer durables freely without a license and without actual user condition. The list of freely importable consumer goods has been further expanded to include 78 items." 3. Further, the following may be added after last sentence of paragraph 2.6 on page 17 of DPR: "However, at the current stage of reform of the Indian economy, elimination of capital account restrictions may be premature." With regards, Yours sincerely, (Signed) (B. R. Khurana) Mr. Luis Landau Acting Division Chief Country Policy, Industry and Finance Division Operations Evaluation Department World Bank 1818 H Street, N.W. This is a reproduction of an original fax received from the Government of India. The original is on file. 28 THu Jun 20 14:12:11 1996 JUN 20 '3 s 23:* 19 Fax: No.001-202-4778391 D.O.No.1297/DS(FB)/96/FB.VI w rqTF Ministry of Financc ROHIT MODI a4f w m A'wr Deparvnemt of EcCononmc AffAirs DEPUTY SECRETARY(FB) 1/ TELE: 3012020 Dear Mr. Penalver, Plea- -fer to our letter of even numbcr datvd May 7, 1996 convoying some or our comments on the draft Performance Audit Report of the External Sector a Investment Regime Liberalisation Loan (No.3627-IN). In continuation of our letter, please find enclosed herewith our further conments in the matter. These comments may kindly be incorporated in the text and as is your practice, thw complete draft may be placed in Appendix-i of the Report. With regards, Yours sincerely, ROIT MODI J Enr.I.A/A Mr. Manuel Penalver Division Chief, Country Policy, Industry 6 Finance, Operations Evaluation Department, The World Bank, WASHINGTON DC (USA) This is a copy of an original fax received from the Government of India. The original is on file. 29 GOVERNMENT OF INDIA'S COMMENTS The External Sector and Investment Regime Liberalization Loan (3627-IN) was approved by the World Bank on 1.6.1993 and agreements signed on 24.6.93. The loan was made effective on 25.6.93, almost 3 months ahead of schedule. The project performance has been well analysed and documented in the Perlormance Audit Report prepared by the Operation Evaluation Department. 2. The World 3ank oporation wo timcly in increasing the competitivencess of India's industrial sector and the export orientation of the economy. Witnout sucn. financing, the transitional costs of adjustment would have been higher particularly in terms of growth and inflation. 3. The loan was particularly successful operation. The objoctivcc of the loan were achieved at Doard Presentation. The restriction on foreign companies under FERA were removed. In the area of liberalization of FERA (Foreign Exchange Regulations Act) and investment deregulation, the PAR goes on to record that the amendments of FERA Act in January'93 led to equal treatment of FERA Companies and domestic investors. FERA Companies were allowed to reinvest dividends abroad wihuuL limiLatiuns and restrictions. In March 1993, 50% foreign equity participation allowed in mining (except hydrocarbons, uranium and coal). These apart, many States had also undertaken procedural and policy reforms to promote foreign investment and to encourage private participation. 4. Market determined single exchange rate in March 1993 was achieved faster than expected, and in August 1994, the Rupee was made fully convertible for all current accounts tronsactions. India accepted the obligations of Article-VIII of the IM1F's Articles of Agreement. The -Government's intention to move towards Capital Account convertibility and hence full convertibility of the Rupee has been made known clearly (The issue is regarding the timin8 of such move and the cpood of trancition). The convertibility of the Rupec iz in fact an integral part of the ongoing economic reforms process. The economic reform package designed to deal with macroeconomic disequilibrium contained long-term market liberalization strategy to promote efficient resource 30 allnntinn and short-term stabilization policies to reduce inflation and BOP diffirulriA. Reduction in fiscal deficits, moderation in inflation, flexible and responsive financial system and sustained/dynamic export perfnrmance are some of the essential pre-condition of Capital Account convertibility. 5. The tariffs were progressively reduced during the period of the loan and thereafter. The maximum tariff rate was reduced from 350% in 1990-91 to 150% in 1991-92, 110% in 1992- 93, 85% in 1993-94, 65% in 1994-95 and 50% in 1995-96. In addition, dispersion and anomalies in tariff structure were also reduced. The range of permissible consumer goods in the SIL has also been increased gradually. C. The remarkable turnaround in almost all the indicators of the external sector during the last two financial years (1993-94 and 1994-95) is by now well established. The dcgrcc of openness of the Indian economy as measured by the ratio of exports and imports to GDP has been showing a rising trend over the last three years, indicative of a greater degree of integration with the world economy. Fxpnrr:n/r,nP ratio has increased from 7.3% in 1991-92 to 9.2% in 1994-95 and Imports/ GDP ratio from 8.3% to 10.6% during the same period. 7. The most prominent improvement was in the current account deficit - CAD/GAD ratio which was -0.1% during 1993-94 compared to -1.8% in 1992-93 and -3.2% in 1990-91. This reflwUtLt sLvong firiprnuenanrR in Awpnr- n^-fmr-monr-o in response to the liberalized exchange rate regime and array of measures to deregulate industry, reform, taxes and reduce customs tariffs. The result was an appreciable improvement in the ratio of current receipts (excluding official trans-fers) to current payments. 8. In the capital account also there has been a healthy restructuring during the last three years. The share of equity in net capital flows (inclusive of transactions with the IMF) soared from 13.8% in 1992-93 to 71.6% in 1994-95. The receding importance of debt creating flows in India's balance of payments have thus strengthened the oxtcrnol scctor management strategy. 9. The liberalization of investment regime and particularly the foreign direct investment regime during the last four 31 years. has made the openness of the system comparable to tnose in the most open economies. As a consequence of amendments of the Foreign Exchange Regulations Act (FERA) in 1993, there is now hardly any discrimination between firms with foreign equity and firms fully owned by Indian nationals. Conditions on portfolio investment 1y foreign institutional investors (FIIs) are much more liberal in India compared to several developing economies including China. The liberalization of the investment regime during the last four years has yielded significant results both in terms of private sector investment spurt and higher growth rates in industrial !production index during last two years and in particular the first quarter of the current financial year. 10. We note that the loan was fully disbursed as per the schedule in December, 1993 and all the covenants were fully law. rlh pLj=%t :utcome haa bean highly OuCccaMful. The economy has responcied well to the stabilization ana structural reform agenda which was further continued after this loan. Given the improvements both in the external sector as well as investment climate, it can be concluded that the IBRD Loan (3627-IN) approved in June 1993 achieved its objectives very successfully. O * as
Группа Всемирного банка · Project Performance Assessment Report
India - External Sector and Investment Regime Liberalization Project
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