CIAO DATE: 2/00

The Indian Economy: A Fine Balance

The South Asia Monitor
Number 3
November 1, 1998

The Center for Strategic and International Studies

 

The Indian economy, with its burgeoning consumer market, skilled labor force, and entrepreneurial private sector, holds great promise. The economic reforms undertaken since 1991 have considerably strengthened it.

The economy, however, presently faces a difficult environment, arising from the Asian crisis, the sanctions following the May nuclear tests, and domestic political uncertainty. The deterioration in the country’s macroeconomic situation that began a year ago has continued, as evidenced by slower growth in output and exports, as well as a higher fiscal deficit and inflation. The government’s June budget failed to provide the reassurance called for in the present climate of uncertainty.

GDP growth has slowed, from an average of 7 percent in previous years, to 5 percent in 1997–1998. This reflects cyclical factors like over-capacity in various industries, but also a slackening in the pace of reforms. If the potential for the economy is to materialize, present difficulties need to be resolved, starting with greater fiscal consolidation and a faster pace of structural reforms. These reforms should make feasible the higher GDP growth rates of 8 – 9 percent that many claim are within India’s reach.

 

Macroeconomic overview:

The public sector deficit (9 percent of GDP in 1997–1998) lies at the heart of the country’s macroeconomic vulnerability. India’s large budget deficit reflects generous central and state government subsidies, the losses of public sector enterprises, and low tax revenues. All these contributing factors are politically entrenched. While a degree of fiscal adjustment has occurred at the central government level, the states’ fiscal imbalances remain intractable. Their lack of fiscal discipline—they provide generous subsidies (particularly for power, irrigation, and fertilizer), but tax land and agriculture minimally—is a major factor contributing to the deficit.

India’s external debt is estimated at US$90 billion (25 percent of GDP). While not excessive by Asian standards, the country’s weak fiscal condition has led to a fragile external credit rating and higher risk premiums for private investors. Debt financing of the deficit has pushed domestic interest rates up to 10–12 percent, crowding out investment. Furthermore, the present structure of expenditures is damaging to economic growth. Subsidies, which account for more than 4 percent of GDP, have been favored at the expense of direct capital expenditures, which account for only 0.7 percent.

The fiscal position has deteriorated in recent months, partly due to weak tax receipts on account of sluggish growth, but more importantly due to inappropriate economic policies. The June budget provides for higher government spending, especially in infrastructure, with few measures to reform the subsidy regime and widen the tax base. The 1998–1999 deficit could be as high as 10 percent of GDP. The expansionary fiscal policies are also fuelling inflation, which has risen to 10 percent, from 7 percent last year.

 

External position:

The Asian crisis and the imposition of sanctions have had an impact, albeit limited, on the economy. They have eroded investor confidence and slowed exports. India’s external position, nonetheless, continues to be relatively stable, although these recent developments call for more cautionary monetary and fiscal policies.

The current account deficit, at 1.6 percent of GDP, is manageable. The current account deficit however is expected to widen to 2.3 percent of GDP in 1998–1999, because of a deteriorating trade deficit and possible weaknesses in remittance inflows. The balance of payments will have to be restored through an improvement in the trade balance, especially in view of weaknesses in the capital account.

Sanctions have weakened the capital account. Foreign institutional investors withdrew more than US$400 million from the stock markets in May and June 1998 and Moody’s downgraded India’s credit rating to below investment grade. Sanctions are projected to cut net inflows of official and portfolio investment to US$1 billion for this year. To offset their impact, the government launched an “India bond”, and raised US$4.2 billion.

India’s external financing position however remains relatively solid given its foreign exchange reserve cushion (US$26 billion, or six months of import cover), the maturity structure of its debt, and its limited exposure to foreign commercial borrowing. Almost half of its external debt consists of concessional long-term debt. Contagion effects from the Asian crisis have been limited by the fact that India’s capital markets are relatively insulated.

The rupee has declined by 9.6 percent against the dollar between January (Rs39:$1) and August of 1998 (Rs43:$1), owing to low investor confidence and rising inflation. It is expected to depreciate further to offset the impact of rising domestic inflation on the competitiveness of exports.

 

Sectoral Trends:

Indian policy now reflects a broad consensus supporting the liberalization introduced since 1991, and there is no push for a reversal. Nevertheless, political factors have slowed the process somewhat. To sustain the impetus, the government will need to open the economy to further competition.

India’s dirigiste path of economic development has meant that public sector enterprises are dominant in most industries. Since 1991, minority equity sales have occurred in only 40 of the 240 central public enterprises. In the latest budget, the government declared a greater commitment to privatization, with plans to privatize Indian Airlines and several other important companies, like VSNL (telecom), GAIL (gas), IOC (oil), and CONCOR (railways). It also announced plans to reduce public equity in non-strategic industries to 26 percent, marking significant progress from previous government efforts. Plans regarding the many loss-making public enterprises are unclear.

Foreign direct investment in India (at US$3 billion or less than 1 percent of GDP) is much lower than in other emerging economies. The investment regime is hampered by lengthy procedures, restrictive land and labor regulations, and the small-scale reservation policy (currently only small-scale firms can engage in the production of reserved goods). In the budget the government sent mixed signals to foreign investors-it committed itself to streamlining approval procedures for investment, but opened up the insurance sector solely to domestic investors; its swadeshi or self-reliance rhetoric is also confounding. Ultimately, the treatment of foreign investment at the central level varies by sector, with foreign investment in infrastructure being especially welcome. At the state level, foreign investment is being more aggressively pursued. The state of Andhra Pradesh has taken the lead in attracting such investment. A Microsoft subsidiary and a new business school (under the aegis of top US business schools) will be set up in Hyderabad.

The government appears committed to private-sector led reform in the infrastructure sector, particularly in power and roads. The main players in the power sector are the State Electricity Boards (SEBs); they control 60 percent of the transmission and 90 percent of the distribution. The SEBs are however in poor financial condition (due to the provision of electricity at subsidized tariff rates, particularly to agriculture, and to losses arising from theft) and are major contributors to the state deficits. The government appears keen to the private sector, whose involvement has been limited by the poor financial condition of the SEBs. It has committed itself to faster clearance of private power projects, to private sector entry in power distribution, and to the establishment of independent electricity regulators. States such as Haryana and Orissa have taken the lead in privatizing their entire distribution networks. On the financing side, the government has agreed to provide counter-guarantees to foreign investors in several large projects. Ultimately, for the power sector in India to be commercially viable, tariff rates will have to be raised from their present subsidized level.

In September, the government announced a list of 12 highways (worth US$2.5 billion) to be developed by the private sector. Investor interest in this sector has been lukewarm, due to uncertainty over whether a toll payment system can be established to create returns for private investors. The government needs to address this issue.

Greater deregulation of the financial sector is necessary to allocate capital more efficiently and to underpin private sector growth. Public banks, many saddled with non-performing loans, heavily dominate the banking sector. The role of private banks, although increasing, is still limited. The priorities are to further open up the sector to private banks and to increase the share of private capital in public banks, establish an internationally standardized regulatory framework, and clean up the public banks’ bad loans. To this end, the budget called for a strengthening of debt-recovery tribunals to help recover loans, although farmers will be exempted. The government has moved toward some deregulation in the financial sector by opening the insurance industry to domestic investors. The move to allow foreign insurance companies access to India remains stalled.

Liberalization of the trade regime has slowed. In September 1997, tariffs on all products except oil were raised by 3 percent. In the latest budget, import tariffs on most products were raised by an additional 4 percent. The reversal in tariff liberalization has coincided with a fall in India’s share of world markets since 1991 and a sharp slowdown in export growth—from 4.6 percent in 1996–1997 to 2.7 percent in 1997–1998. The slump in Asia and the fall in international commodity prices have hurt Indian exports. Nevertheless, the decline is as much due to internal factors such as infrastructure constraints, lack of access to capital by small-scale exporters, and a complex tariff structure. Tariff rates are twice as high as the average in East Asia and Latin America. It will be hard to jumpstart India’s export growth until its tariff and non-tariff barriers are reduced.

 

Program Notes:

Professor A. Varshney of Columbia University and Economic Times correspondent S. Aiyar led a spirited discussion on the first six months of the Indian government at our conference on October 15. Prof. Varshney argued that Prime Minister Vajpayee had neutralized the threats from his coalition partners for the time being, but faces a much more serious threat from the right wing of the Hindu nationalist movement. The movement relies on its hard-liners to mobilize the faithful, but their political agenda and desire for representation in key ministries were slighted. They will try to pull the government to the right, whereas the party needs to show a moderate face in order to win elections.

On the economic side, Aiyar described India’s move from a national consensus on socialism to one favoring half-baked economic liberalization. Shaky government finances rather than ideology led the government to begin privatizing publicly held industry. The BJP’s call for economic self-sufficiency (swadeshi), he felt, was a paper tiger. Its only victory so far was the failure to open the insurance sector to foreigners. Aiyar was confident the thrust of policy would remain one of liberalization at a modest pace.

Upcoming events include a discussion on recent developments in Pakistan with Professor Weinbaum and Mr. Shahid Husain (November 4 at 9 A.M.) and a discussion on India’s security perspective with Mr. S.K. Singh and Dr. Raja Mohan (November 9 at 4 P.M.).