India after two decades of Reforms – The Challenges Ahead

Dhananjay Ghei

2011

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ContentsAbstract ……………………………………………………………………………………………………3

Introduction……………………………………………………………......................................................4

The Crisis of 1991..............................................................................................................................4

Economic Reforms of 1991…………………………………………………………………………4

Economic Reforms – An Appraisal………………………………………………………………….5

The Challenges ahead………………………………………………………………………………………7

Part I: The Bubble in Service Sector………………………………………………………………………..7

Structural Transformation – Where is the problem? ...........................................................................8

Part II: Growing Inter State and Rural-Urban Inequality…………………………………………………..9

Part III: Social Infrastructure……………………………………………………………………………...11

Conclusion………………………………………………………………………………………………..12

References…………………………………………………………………………………………………14

TABLESTable 1: Sectors attracting highest FDI equity inflows……………………………………………………..7Table 2: Statement on Sector Wise FDI Inflows from April 2000 to April 2011………………………….8

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Table 3: State Level Human Development Indices…………………………………………………………12FIGURESFigure 1: FDI inflows in India- Post reform period………………………………………………………….5Figure 2: India’s GDP since Independence, shows the growth rate has been comparatively high in the post reform period………………………………………………………………………………………………6Figure 3: Widening Disparity among the richest and the poorest states of India…………………………….9Figure 4: Trends in average monthly per capita consumption expenditure for rural and urban areas……….11

Abstract

India since independence had been growing at a very low rate in terms of its Gross Domestic Product. India has followed central planning for most of its independent history, which have included extensive public ownership, regulation, red tape, and trade barriers. The increased external borrowing from foreign sources to fuel economic growth led to pressure on balance of payments. Apart from that strict policies followed by the government at that time and huge expenditures faced during the time of wars led to a condition where it seemed almost impossible to come out of the crisis. The then finance minister Dr. Manmohan Singh, reformed the policy that India had been following and paved a way for a free economy. Dr. Singh introduced more competition, both internal and external, simplified the tax structure and tried to create an environment conducive to the growth of business. The economy started opening up to the world and this became a turning point in Indian economy. India now evolved from nowhere in two decades as the fastest growing economies of the world after China. Although it is argued upon that the reforms have reached only a few of the people because there has been a boom in

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the service sector. The service sector has been growing at a very high rate than any other sector. Although the chief agenda of the reforms was to achieve higher growth rate but still there is high rate of poverty in India and various other socio-economic issues that need to be addressed. The paper examines the changes that India has gone through in the past twenty years, the plans that worked and where it dint. It also gives a brief insight into the sector wise analysis of the impact of reforms in the past two decades.

IntroductionThe Crisis of 1991

India for a very long period was trapped in the low level equilibrium rate of growth at 3.5 percent, however in 80’s India witnessed a relatively steady growth performance, lower inflation and a steady decline in the proportion of population under poverty. The decade also saw a rapid rise in revenue expenditure resulting from the Gulf War, because of which India’s oil import bill swelled, exports slumped, credit dried up and investors took their money out. The fiscal imbalances were large and were still growing. Large fiscal deficits, over time had a spillover effect on the trade deficit culminating in an external payment crisis. The fiscal deficit of Central government rose to 8.4% of GDP in 1990-91. The foreign exchange reserves had dried up to the point that India could barely finance three weeks worth of imports.In mid-1991, India’s exchange rate was subjected to a severe adjustment. This event began with a slide in the value of the rupee leading up to mid-1991. The authorities at the Reserve Bank of India slowed the decline in value by expending international reserves. With reserves nearly depleted, however, the exchange rate

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was devalued sharply on July 1 and July 3 against major foreign currencies. (V Cerra and S C Saxena, 2002)Thus India faced a severe crisis resulting because of currency overvaluation, current account deficit and investor confidence that played a major role in the sharp exchange rate depreciation.

Economic Reforms of 1991

A newly appointed Narasimha Rao government faced severe crisis. India had to pledge 67 tons of gold reserves as collateral for a loan of $2.2 billion from the IMF. The International Monetary Fund (IMF) agreed to assist the Indian government, in exchange for some concessions, to put the Indian economy back on track.  The License Raj had to be dismantled, and reforms would have to be initiated.   Faced with no other option, Manmohan Singh and PM Rao agreed to the package. India had no other choice but to swim with the flow and hence headed towards liberalization. The Rao government recognized in 1991 that the time had come to reshape India’s economic policies by drawing appropriate lessons from the ‘East Asian Miracle’ based on more export-oriented and more globally connected strategies of development, as successfully practiced earlier by Japan and South Korea and also by the South East Asian tigers Malaysia, Singapore, Indonesia and Thailand. (C D Wadhwa)Thus on 24th July 1991, the government announced the New Industrial Policy, marking the start of India’s economic reforms. The main objectives of these reforms were to initiate competition from both domestic and foreign production, which will increase the efficiency of the market and also achieve a higher rate of growth. However India has been following a “gradualist” approach in the area of reforms and the strategy driving change was to pick areas where the probability of success was highest and use that as a springboard to enact further change. It has been twenty years since then and there has been no looking back.In 2009, it is the IMF that has sold gold to India to 'borrow' money to loan to poor nations. That is indeed irrefutable proof that the economic reforms that Manmohan Singh set in motion have borne fruit. On September 18, 2009, the IMF's executive board approved gold sales strictly limited to 403.3 metric tonnes, representing one eighth of its total holdings. India and China were seen as the likely buyers the IMF gold, given the two Asian giants' economic strength even in the face of the global recession that ravaged most economies.Despite the slow pace of implementation of the economic reforms and certain hiccups and delays caused primarily by the compulsions of democratic politics, the performance of the Indian economy under the reforms carried out so far shows a mixed picture of notable achievements and weaknesses. The performance has been impressive on some fronts, satisfactory on several other fronts, and inadequate in certain respects. India has still to launch deeper (so called ‘second-generation’) reforms in various areas to get the best results.

Economic Reforms – An Appraisal

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India’s reforms have been piecemeal and incremental, giving the casual observer the impression that nothing has been happening. If one takes the totality of reforms over the last decade, however, the change is unmistakable. The analogy is with the hour hand of the clock, which looks completely static, and yet completes a full circle every 12 hours. (A Pangariya, 2001)India, from being an economy trapped in a low growth equilibrium trap as late as the 1980’s became the second fastest growing large economy in the world two decades later. India witnessed a high GDP growth rate almost all these years with macroeconomic stability. Apart from this in 2010-11 exports were $247 billion and imports $359 billion. They collectively amount to 30 percent of GDP, a significant increase from the pre liberalization era. The change in investment regimes and its impact is equally striking. Foreign direct investment (FDI) in India increased from virtually nothing in 1990 to $25 billion in 2010 (Figure 1). FDI has made domestic firms more competitive by forcing them to upgrade their technology, which in turn has enabled them to expand to more efficient scales of production.

Figure 1: FDI inflows in India- Post reform periodSource: World Bank, World Development Indicators

Reforms were primarily made in the Industrial Sector, but also liberalization occurred in trade, public sector, fiscal and foreign investment policies. It was felt that although growth is important but it should come with a better macro-economic situation of the country and a stable economy with less of fluctuations, which was not looked upon in the previous years.

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Figure 2: India’s GDP since Independence, shows the growth rate has been comparatively high in the post reform periodSource: World Bank, World Development Indicators

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The Challenges ahead

The Bubble in Service Sector

On data and figures if we believe the picture of India portrayed seems much better than what it was before 1991. With the LPG (Liberalization Privatization Globalization) model put in practice since 1991, the services sector has in recent decades been performing much better than agriculture and industry in India and in many other developing countries as well. According to standard literature, services experience an accelerated growth only after a certain level of development in agriculture and then in industry. In this regard, the Indian experience is somewhat different. Even today India cannot be considered as an industrially developed economy. (D Chakravarty 2005) Service Sector in India today accounts for more than half of India’s GDP. According to data for the financial year 2006-07, the share of services, industry and agriculture in India’s GDP is 55.1, 26.4 and 18.1 per cent

respectively. The emergence of India as one of the fastest growing economies in the world during the 1990s is attributable to the rapid growth of its services sector to a great extent. The sector has been experiencing double-digit since 2004-05 importantly, a strong growth of 10 per cent in 2005-06 has beeninstrumental in providing an impetus to overall real sector activity in the economy. There has been a structural transformation in India. Many economists argue against the growth led by services sector. The reforms introduced were to enhance the industrial sector, no doubt industrial sector grew because of FDI inflows but the FDI has not been promoted in this sector, than it has been in services sector. Data from Table suggests that the maximum inflow of FDI has been in the services sector (both financial and non-financial) accounting to 21 per cent of the total FDI inflows in 2011 whereas industry lagged far behind, with automobile industry getting one tenth of FDI inflows of services sector. Moreover a data analysis from 2000-11 suggests that there has been a robust growth in the amount of FDI inflows in the services sector (20.83 per cent over the period of 11 years) whereas industry present a somewhat gloomy picture. FDI inflows have not grown in comparison to the investment that the service sector is getting over the years. A somewhat unequal distribution of inflows suggests that there has been a loophole in policy framework. We approve with the “gradualist” approach suggested by policymakers but twenty years seem to be quite a long time and as we proceed we need to promote industries and use their latent potential in contributing to growth.

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Table 1: Sectors attracting highest FDI equity inflowsSource: Department of Industry Policy and Promotion, Ministry of Commerce and Industry India

Table 2: Statement on Sector Wise FDI Inflows from April 2000 to April 2011Source: Department of Industry Policy and Promotion, Ministry of Commerce and Industry India

Structural Transformation of India: Where is the problem?

With the services sector growing more than 9 per cent in the past twenty years and Indian industries growing at 7 percent, there has been a major shift in the contribution pattern of each sector in the GDP growth. There has been a structural transformation in the sectors since the opening up of Indian economy, which many consider as a distortion or as a lack on the government part in attracting FDI inflows to Industrial Sector. However, there is still a different question that remains unanswered and is a strong point of my argument that will the service sector be able to sustain this high level of growth?

In a report by A Virmani, he states that the relatively fast growth of modern services can be sustained till India reaches the high income category this will not necessarily result in a faster shift of the labor force out of agriculture. (A Virmani, 2006) However, a faster growth in services implies a faster growth in demand of educated

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and skilled labor instead of unskilled labor. This requires a shift of unskilled labor to the skilled side. Well, this is one important question that has been raised by many. It has been generally argued that is India going to face a labor shortage in future? The ability of India's educational system to meet the ever-growing demand for skilled labor faces many challenges. Improvements in their higher education system show signs of slowing (Gupta, 2007). A slowdown of capital flowing into education or a deceleration of productivity resulting in that sector would seriously hamper the growth of India's skilled labor supply. Add to that the fact that many females receiving their degrees in that sector choose not to enter the labor supply, and the imbalance between supply and demand growths is exacerbated. Cultural and social changes will be needed to bring more of those females into the workforce if India has any hope of seeing its skilled labor supply keep up with the demand. Absent of such changes, India, is destined to see its skilled labor force continue to fall short of those of China and the United States in meeting the insatiable worldwide demand for skilled labor. (H Beladi, S Marjit and K Weiher, 2011)In 2009 the IT and BPO alone employed over 2.2 million people in this sector, and the number is likely to increase in near future if we need to sustain growth. Certain steps have been taken in the past to increase the seats and forming new institutes of learning but they are still inadequate in comparison to the demand that we face. The sustainability of high growth in service sector lies in the effective implementation of policies and high input of educational capital in India, to generate a large force of “quality” skilled labor to be able to absorb the demand of the industry. Not only this but as it has been argued upon earlier that the industry needs to contribute more towards growth and the country has to increase its potential and attract more of FDI’s in this sector. There lies a lot of unfinished agenda of growth and if the country foresees growth in future it has to lay strong foundations in this area.

Growing Inter-state and Rural-Urban Inequality

Various papers that have come in the past have been constantly discussing the performance of the economy as a whole or of individual sectors. However, recent debate has been raised on the growing inequality among states during the post-reform period. Many economists and policymakers are of the view point that the reform led growth has been responsible for the growing disparity but many argue against it. It has also been considered as a major reason for growing poverty in these states.Macroeconomic data for 14 different states reveal the extent of inter-state differences in the pace of economic growth in the past decade. There has been rising inequality in the performance of the states. Many states have done far better in the post reform period whereas others have not performed well. In 2002-2003, the per capita Net State Domestic Product (NSDP) of the richest state, Punjab, was about 4.7 times that of Bihar, the poorest state. This ratio had increased from 4.2 in 1993-1994. Ghosh and Chandrasekhar (2003) showed that inter-state inequality increased sharply in India during the reform period. As the authors pointed out, based on per capita SDP, the basic hierarchy of the Indian states remained the same during the reform period, with Punjab, Haryana and Maharashtra at the top,

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and Bihar and Orissa at the bottom. They also noted that the gap between the richest and poorest states opened up considerably after 1990-1991. To illustrate this, the authors benchmarked the average per capita net SDP of the three richest states (Punjab, Haryana and Maharashtra against the average per capita net SDP of the two poorest states (Bihar and Orissa)

Figure 3: Widening Disparity among the richest and the poorest states of India

Montek Singh Ahluwalia in his report on the state level performance of the reforms states “Because of state specific characteristics, the divergent patterns of economic growth witnessed in the 1990s do not necessarily imply that the economic reforms at the national level were biased. But to mitigate such regional differences in the future requires deepening reforms and addressing the specific deficiencies that have decelerated growth in some states.”But reports say a different story, Dr. N J Kurian of the Planning Commission who made an extensive study of the same found out that more than two-thirds of the investment proposals (69.2 per cent) in the post reform period were concentrated in the forward states and a similar situation prevailed in terms of financial assistance distributed by All-India Financial Institutions as well as State Financial Corporations. (Kurian 2000)Ahluwalia points out the need to look into the causes of high performance of the states and imitate the policies undertaken in under developed states. He in his paper using cross sectional analysis found that variations in the private investment

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ratio are positively and significantly correlated with variations in growth, while public investment and plan expenditure seem to have had little direct impact. It also finds that provision of certain infrastructure, and to some extent also literacy, are associated with variations in growth. (Ahluwalia 2000)Another dimension of inequality which has acquired serious proportion concerns rural and urban areas. Per capita consumption expenditure in real terms, obtained from NSS, show low growth during the first three decades since Independence both in rural and urban areas. The growth has, thereafter, picked up, particularly in case of urban areas, the rise being very steep in the nineties and subsequent years. This can be attributed to the growth in non-agricultural GDP (8.11% and 7.22% during 1993-99 and 1999-2004, respectively). Both these rates are significantly higher than the corresponding rates for agricultural GDP. Both these rates are significantly higher than the corresponding rates for agricultural GDP. This has led to significant divergence between the two over the years as portrayed in Table 3, when both are taken to have the base year figures of 100. (A Kundu and P C Mohanan)

Figure 4: Trends in average monthly per capita consumption expenditure for rural and urban areas, 1972-73 to 2004-05Source: NSS Report no. 508

There is a dire need of raising the education level and attracting private investment in the states where growth has not been achieved to the desired level. There needs to be a huge investment by the government to develop the necessary infrastructure and create opportunities for the investors. With state economy performing well, it shall automatically raise the standards of living of the people, increase literacy rate and shall reduce the number of poor in these states. India’s democratic setup brings up regionalization of politics and this hinders the development process therefore, concrete efforts in this area have to be taken both at the central and the state level.

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The growing rural-urban inequality since the post reform period is of serious concern and steps like promoting agriculture and farm related activities and to drain out the excess labor that the sector is having because of lack of quality education needs to be tackled at the earliest.

Social InfrastructureIf the purpose of all development is to improve the quality of life, then human development indicators are the end products of the development process. (Datt and Sundharam 2010) Wide disparities have been observed among different states. Higher levels of human development indicate a potential of growth and development, and to achieve this we require large amount of investment in educational and health sector.

Table 3: State Level Human Development IndicesSource: Planning Commission (2002) Findings of a Report by P. Duraisamy and Ajay Mahal, using econometric models found out that the States that have experienced higher (lower) levels of growth over the thirty-year period witnessed a lower (higher) level of poverty, except Kerala and West Bengal. Also, another important conclusion that that they achieved was a strong positive association is observed between initial per capita income and long-run economic growth in per capita income across the States. That is, States with a higher initial income have grown faster than States with a lower initial income. This has the effect of widening the gap between the rich and poor States. Thus in the long run there has been a growing disparity between the states. (Duraisamy and Mahal)Backward states have not performed well either in the two sectors. Private sector which is considered to invest in this sector has set up various hospitals and educational institutes but only to serve the upper middle class or the rich class. Nothing significant has been done for the welfare of the poor. Significant work has to be done in this field as it is the manpower that will only lead to growth and we need a lot of manpower. The health of the people and the level of education they

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get is utmost necessary for development of a country like India. Backward states are not able to attract private investment because of unfavorable investment climate including poor infrastructure. They themselves are unable to improve the investment scenario in their states and thus government has to take steps in order to improve the status quo of these states and improve the existing poor infrastructure facilities to facilitate growth and development.

ConclusionThe economic reforms since past two decades have brought overall growth and have been a key factor in the development of our country. India emerged from nowhere in 1990’s to the world as the second fastest growing economy of the world. Undoubtedly the reforms have been a key factor in bringing a change in the standards of living of the people. A lot has been achieved in the past two decades and still there is a lot of unfinished agenda on which we have to work upon. The growth of industries has to match the pace of rapid growth in population that is being faced by India. Bigger and tougher challenges are ahead if we want to sustain the growth, an India has to bring in what the economists have been saying “Second Generation” reforms.Apart from that the bigger issue is of Corruption, the reforms have given more leverage to the officials and given more power at hand to favor it. For proof, consider the Bofors scandal in the eighties. The major corruption scandal, which brought down a government, was about 64 crores in kickbacks. The loss to the exchequer in this year’s 2G spectrum allocation scam is 2600 times higher than that at 1.76 lakh crore. These kinds of leakages adversely affect the economy and needs to be tackled at first hand. Another issue is the development of necessary infrastructure in backward states to attract private investment and facilitate growth. It is the role of government to develop infrastructure and provide avenues for investment rather than playing politics on who’s got a bigger role the centre or the state. A delay occurring in passing of funds for projects is a common scene. The problems at hand are very deep and have to be eradicated from the root to implement changes and help in narrowing down the gap between the states. Increase in corruption and lack of infrastructure are still pockmarks on India’s face.The abnormal rise in service sector that has facilitated growth needs to be sustained in the long run to bring macro-economic stability in the country. India needs to provide large number of skilled labor to maintain the growth in this sector, and thus require large amount of educational capital to develop higher institutes of learning and increase literacy in India.

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