Macro challenges


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THE year began amidst another financial scam that erased the euphoria created by yet another dream budget of the central government. Declining export growth, sagging capital markets, flat industrial output and, finally, a drop in tax revenues reminded us that growth cannot be taken for granted. Depressingly large foodgrain stocks with the government and substantial forex reserves of the economy were further reminders that efficiency is not yet a feature of the economy.

The silver lining of the IT led boom began to look more mortal with the slowing down of the US economy. In fact, the melting of ICE (information, communication and entertainment/electronics) and hi-tech stocks began the woes of the capital markets. Dissatisfaction with the pace of reforms or apprehensions about the fiscal health led to lowering of ratings by the international debt rating companies. Externally, the shock of terrorist attacks in the US and the apprehension of anticipated consequences have further created uncertainty for investors and policy makers.

The year has had its share of uncertainties and shocks. Policy making in a situation where expectations are high and flexibility low would indeed be risky in terms of what is achieved and what is attempted. This paper looks at the economic scenario unfolding today in the context of some of the major developments in the past decade, implications for the future and for policy.



The setting for the present analysis can be thought of in terms of three sets of factors: (a) initial conditions that capture the policy context and the impact of past developments, (b) exogenous factors such as the global economic conditions that affect both the supply and demand conditions and the ever important monsoon, and finally (c) the policy actions that aim at influencing the course of the economy.



The initial conditions for the year were the experiences of the economic reforms of the 1990s. The need to take the reforms forward became more apparent with the slowing growth of the economy. The 1990s indeed saw a possibility of momentous changes in the economy. After a decade of numerous changes in policies that were fashioned in the previous decades, the feeling today is still one of an unfinished agenda, or more accurately one of a job that should have been done better. While at the global level India’s performance has been respectable over the last two decades, her position remained unchanged as one of the poorer nations both in the 1990s and in the 1980s.

At the end of 1990s, the weaknesses in the economy came to the fore. Expectations of sustained rapid growth as seen in the case of China, once the policy changes were made, quickly waned as real GDP growth which averaged 7% per year during 1994-95 to 1996-97 came down to an average of less than 6% in the next four years. The policy changes introduced in the 1990s have not been one of uniform pace or character. The results also have been distinctly patchy – remarkable with respect to moderation in inflation rate and improved balance of payments, impressive with respect to even growth, but disappointing in sustaining private sector investments to generate new employment opportunities.

During the 1990s, private corporate sector investment rose faster than public sector investment. As the manufacturing sector could not quite stand up to the global standards of productivity and quality, Indian enterprise turned to the services sector where it could catch up with world-class technology. There are some benefits of being tardy. The service sector grew fastest in the 1990s among the three broad segments of the economy. Within services, financial services, transportation and communications made rapid gains. Information technology has become an area of significant strength for the Indian economy where it can offer its software services to the global markets on a competitive basis.



The Indian economy is now looking at a scenario where entrepreneurs are hesitant to make new investments as their economic viability is uncertain. The uncertainty is one of international competitiveness. Foreign investors, who made investments to benefit from the large Indian markets perhaps now find producing elsewhere and selling here more attractive. The policies are unable to translate intentions into reality. The rate of realization of foreign investment proposals is less than 20% on a cumulative basis for the period 1991 to 2000. In other words, foreign direct investment could easily have been $7 billion per year if all the proposals were turned into reality. The actual inflows were only an average of $2 billion per year.

The 1990s saw the emergence of services as a major source of growth for the economy. Services together accounted for about 60% of the growth in GDP during the period as against its share of 50% in the 1980s. Both agriculture and industry showed less impressive growth despite the fact that economic reforms of the 1990s were aimed at reforms in the industrial sector. Within services, communications, financial sector and business services, which includes, IT fared much better than the other sectors.



The impact of reforms on employment was unimpressive. Employment in the organized sector grew by about two million in the 1990s as compared to about 3.5 million in the 1980s. More striking is the pattern of change in the shares of public and private sectors. In the organized sector, employment in the public sector grew by less than one million in the 1990s while in the previous decade growth was over three million; in the private organized sector employment increased by more than one million in the 1990s whereas there was hardly any growth in this sub-sector in the 1980s.

Thus, the reforms did lead to growth in private sector employment but it was not enough to offset the drop in the growth of public sector employment. The slower growth of employment in the organized sector in the 1990s points to a greater burden on the unorganized sector in catering to the livelihood of the rest of the population. Agriculture and unorganized manufacturing, which saw less than impressive output growth in the 1990s, have had to absorb a larger labour force than in the previous decade.

The challenge is one of achieving sustained growth, generating employment and providing social safety nets. Clearly these are not new objectives; nearly all the economic policy statements to-date have voiced these sentiments. The 2001 Census confirmed that India is a nation of over one billion people, the second largest country in terms of population after China. Many Indians are poor, with incomes barely enough to keep body and soul together. While estimates show a reduction in the share of poor in the total population, the absolute numbers are too large for comfort.

What then are the constraints in achieving the objectives? The pre-1990s strategy became unviable because of the rising uncompetitiveness of Indian industry. The protection needed for Indian producers, barring much of agriculture, turned out to be nurturing inefficiency. As a result, our export earnings were inadequate to cover import requirements and capital flows became a trickle. Fiscal support to everyone became an unviable proposition: someone had to pay.

The post-1990s reform strategy was based on improving competitiveness of Indian producers, and to achieve better export growth performance. The reforms so far have not achieved these objectives. India is still not attractive enough a place to set up new factories/production facilities despite the lure of large markets. The difficulties are numerous, nearly all of them equally important. Be it reducing corruption, improving legal and administrative framework, moving quickly on decisions – the potential for improvement is enormous, but expectation is low.



Given the constraints on progress towards long-term solutions, it is useful to focus on short-term problems. The year has seen clear conditions of slowing aggregate demand under the weight of a diminished investment climate. Capital markets, in the midst of an on-stage learning act, have exacerbated the pessimism resulting from global slowdown in economic activity. If one were to estimate the potential level of GDP from existing capital stock, real GDP growth for the year would be 2-3 percentage points above the currently estimated 5.6%. Of course, some of the capital stock would be noncompetitive and cannot be moulded into something else and hence not likely to be used for production. But then, new investments would be needed to make the existing capital stock competitive or to establish new capacities that would be competitive.



The global economic slowdown was evident by the beginning of the current fiscal year. Export growth had dropped by the final quarter of the previous year to a mere 5% from the over 30% growth in the first quarter. A noticeable number of Indian IT professionals returned from the US as business was on the decline. Depressed international prices kept the domestic inflation rate at moderate levels despite the bursts of oil prices during the year.

The demand conditions, therefore, became sluggish while there were no supply constraints. Slowing demand, however, also meant that Indian exporters had to compete with the rest for a smaller share of the markets in the developed economies. In the wake of the Asian financial crisis in the later half of the 1990s, exchange rates in the Southeast Asian countries went through a sharp devaluation. The Indian rupee remained ‘stable’, implying a new set of relative prices for exporters.

The monsoon that was unsatisfactory in the two previous years was projected to be ‘normal’. As the year progressed, the southern states of the country saw relatively poor rainfall in the monsoon period. In the last two years, agricultural output stagnated with less than 1% growth in GDP from agriculture. While the monsoon played truant, the government granary was bursting at the seams. Also, while agricultural growth was poor, agricultural prices remained depressed. Suddenly, the rules of the game were different for agriculture.

The Union budget was an attempt to nudge up investment spending by the private sector. The tone was earnest and fiscal relief to the corporate as well as individual income tax payers followed it up. The government also reduced the interest rate on small savings in order to help the process of bringing down the interest rates in the economy. The monetary policy that was announced in April followed up the fiscal stance of being helpful to new investments. The Exim policy attempted to give new props to the export effort, while abolishing quantitative restrictions on imports of consumer goods. Special Economic Zones were announced.



The policy actions, however, also point to the constraints on policy making. Take the case of managing the fiscal deficit. It now appears to be a general view that the fiscal deficit should not be allowed to move up from the present level; in fact, that it must be brought down. The budget estimates took credit for the Rs 12,000 crore disinvestment revenue and managed to show a fiscal deficit estimate of 4% of GDP for the year. The government needs more revenues to bring down the deficit. It cannot raise taxes from agriculture and services effectively, it does not want to reduce subsidies and it has no resources to improve social sector services and provide for social safety nets.

The need to raise spending on infrastructure projects, to attract private investment into infrastructure projects was, however, addressed only symbolically. While it is true that state governments have much more to do in restoring the financial health of their own state electricity boards, the options available to them are also unlikely to be attractive, thus, reducing chances of their adoption. The power sector scenario is turning into one of negative outlook, making progress on a key infrastructure requirement a non-starter.

Progress in telecom and roads is more noticeable than in the power sector. In the case of telecom the problem of revenue collection has not been an issue and in the case of roads, the government has been able to mobilize resources through levy on petroleum fuels. Clearly, where resources are available, infrastructure development is promising.




The cyclical factors have a way of sorting themselves out. A good monsoon will mean better crop output and therefore a push for aggregate output of the economy. Rural demand for manufactured products will improve. Agro-based industries can acquire raw material at lower cost, transportation activity will pick up. But again, the flaw in the policy frame will be evident in the rising flow of grain into government stocks.

A recovery in the US economy and the rest of the developed world will mean a pick up in demand for world output. The current state of tension does create uncertainty on the pace of recovery and on the safety of global transportation to facilitate trade. The unsettled state of global trade also poses a risk of volatile petroleum prices. But at this time they can only be possibilities with considerable consequences to the global economic conditions.

Therefore, a conservative view would be: a continued poor state of the capital markets with FII investments at a low ebb and other foreign investments in Indian companies unlikely to do better, export demand to pick up slowly and petroleum prices to be higher on the average than in the last year.

Finally, the cyclical drop in investment may begin to see some upturn. The new investments will be related to rationalization, modernization and upgradation of production facilities. Construction activity can be expected to show significant growth primarily because of government spending on roads and related infrastructure as well as housing investment by individuals. It is not clear how much money has gone to individuals who have exercised various VRS options in the last two years. Not all the money has been paid in cash either. But it is likely that substantial payments may have gone into housing construction as well. Construction is an area where import competition is not yet an issue. Investment spending, therefore, may see slight improvement in the second half of the year.



Government spending will of course increase, spurring some production activity. It is also likely that government will aim at using some of the large foodgrain stock to fund rural infrastructure projects. Again, the focus would be construction activity. Will there be a spate of give-aways? While the temptation is great, the chances are small. One of the main reasons for greater prudence would be the adverse impact on foreign investment and capital flows. While spending on infrastructure development will get a sympathetic hearing, profligacy would be more expensive.

It is interesting that in a year of so much uncertainty, the fear of inflation is minimal. International shocks may yet cause some concern, but availability of large foodstock, large forex reserves and a reasonable monsoon has contributed to a sense of security about supplies of essential commodities. The monetary policy has remained easy with respect to interest rates and liquidity. Although real interest rates remain high, cuts in nominal rates can be expected should the signs of recovery emerge.

The prospects in the short term are, therefore, for one of slow recovery of industrial output growth. Agricultural growth will recover from its poor performance over the last couple of years. But growth in services is unlikely to match the performance of the earlier years.




Economic reforms are again in the news. The constraints on higher growth can be identified with slowing or lack of reforms. Will the reforms get another push? Political initiative for reforms is likely only if the benefits can be expected to reach the masses. A high growth rate will benefit the masses but it should also benefit them directly. Employment generation effect can create a mass appeal; agricultural growth can create mass support for reforms. However, for these effects to materialize, there has to be a revival of investment.

In the mid-1990s, investment took off with deregulation of industrial activity. Further revival of investment activity will depend on reforms in infrastructure sectors. Investment activity will also revive with improvement in governance. We have a wealth of lessons in the unrealized foreign investment proposals of the last 10 years.

There has to be a shift in government policy in spending in favour of the creation of assets and infrastructure. Institutional changes to make effective public or private investment in infrastructure possible need consideration. Revenue mobilization should not be side-tracked. Raising revenues for improving competitiveness of agriculture and industry would be an essential step in the path towards higher growth.

Can the high growth rates be sustained? It would be difficult to fully address this question if we ignore the condition of the economy at the state level. The states will have to play an equal role in reviving investment expenditures. The fiscal position of the governments at the state level, however, does not allow them to make investments in infrastructure. This is not merely because of a lack of resource, but due to misplaced priorities in spending. Mechanisms for introducing user charges for services rendered by the government are generally inadequate. Equally, mechanisms for monitoring the effectiveness of expenditures in providing services appear to be inadequate. Systematic and faster methods for assessing performance of government programmes and corrective actions at the state level are more likely to improve governance.

The performance of states such as Gujarat, Maharashtra and Karnataka in attracting new investments relative to the others requires an understanding of the strengths and weaknesses of alternative approaches. Irrigation proved to be the key to the success of agriculture. States where potential existed benefited. Investment in infrastructure for developing human resources will help the states in attracting investments. But good governance may also prove to be a key to success in industrial growth.

The challenge is not merely one of raising resources for new investments, but to make investments that will be globally competitive. The role of the government will not end by withdrawing constraints on private sector participation. It should find efficient ways of creating conditions for higher economic growth. The medium term prospects, therefore, will depend on the extent to which reforms proceed further. Disinvestment programmes, infrastructure investments and their impact on capital inflows and exports hold the key for sustaining the present momentum of growth.


* The views expressed are the author’s personal positions.