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C) 1994 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W., Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing July 1994 The World Bank Comparative Macroeconomic Studies series emerges from a research project that reviewed the macroeconomic experiences of eighteen developing countries over a period roughly from 1965 to 1990. So that the studies might be published with relatively little delay, the books have been edited outside the World Bank's Office of the Publisher by the Macroeconomic Research Department. The findings, interpretations, and conclusions expressed in this publication are those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to the members of its Board of Executive Directors or the countries they represent. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood,Dr., Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Wash- ington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'1ena, 75116 Paris, France. Cover design by Sam Ferro. Vijay Joshi is a Fellow of Merton College, and 1. M. D. Little is an Emeritus Fellow of Nuffield College, both in the University of Oxford. Library of Congress Cataloging-in-Publication Data Joshi, Vijay. India: macroeconomics and political economy, 1964-1991 / Vijay Joshi and I.M.D. Little. p. cm.-(World Bank comparative macroeconomic studies) Includes bibliographical references and index. ISBN 0-8213-2652-X 1. India-Economic policy-1961-1966. 2. India-Economic policy-1966- 3. India-Economic conditions-1947- I. Little, lan Malcolm David. II. Title. III. Series. HC435.2.J7 1994 338.954-dc2O 93-33147 CIP Contents Foreword xiii Acknowledgments Av Acronyms xvii Data Notes xviii Introduction I Part One History, Profile, and Institutions Chapter 1. Recent History and a Profile of the Economy 7 Recent History 7 A Profile of the Indian Economy 12 Chapter 2. The Structure and Working of Markets 25 Indian Labor Markets 25 Indian Internal Capital Markets 30 Indian Product Markets 36 Part Two Macroeconomic Crisis and Adjustment Chapter 3. A Sketch of Political and Macroeconomic Developments from 1964 to 1991 47 1964/65 to 1970/71 47 1971/72 to 1978/79 52 1979/80 to 1984/85 58 1985/86 to 1990/91 62 Overall Trends in Political Economy, 1964/65 to 1990/91 67 Chapter 4. The Crisis of 1965-67: Antecedents and Consequences 73 Droughts and Public Deficits Superimposed on a "Quiet Crisis" 73 The Donors' Concern with the Quiet Crisis: The Bell Mission 74 The Devaluation Negotiations and Their Effects 75 The Crisis Itself: The Policy Response 76 The Aftermath of the Crisis: 1968-69 to 1970-71 82 .V vi India: Macroeconomics and Political Economy, 1964-1991 Should It Have Been Different? Could It Have Been Different? 94 Appendix 96 Chapter 5. The Crisis of 1973-75: Causes and Resolution 105 The Causes of the High Inflation of 1972/73 to 1974/75 106 The Causes of the Balance of Payments Deterioration of 1973/74 and 1974/75 113 Inflation: Resolution and Consequences 115 Resolution of the Balance of Payments Crisis 121 The Sequel to the Crisis: 1975/76 to 1978/79 123 Assessment of Macroeconomic Policy and Adjustment, 1971/72 to 1978/79 128 Appendix 129 Chapter 6. The Crisis of 1979-81 and Its Aftermath 143 The Causes of the High Inflation of 1979/80 to 1980/81 143 Causes of Balance of Payments Deterioration 147 The Course of the Crisis and the Policy Reaction, 1979/80 to 1981/82 149 Inflation: Resolution and Aftermath 151 Capital Forrnation during and after the Crisis 153 The Behavior of Output during and after the Crisis 154 Effects on Absorption and Income Distribution 154 Non-Adjustment of the Balance of Payments after the Second Oil Crisis 155 Deterioration in the Public Finances 163 An Assessment of the IMF Loan 167 General Assessment of Macroeconomic Policy during and after the Shocks of 1979 and 1980 168 Appendix 169 Chapter 7. The Road to Crisis, 1985/86 to 1990/91 180 Public Finances 180 Balance of Payments and External Debt 182 Inflation /89 Growth 190 Overall Assessment 190 Appendix 191 Chapter 8. Crisis and Short-Term Macroeconomic Policy: An Appraisal 201 Appropriate Response to Exogenous Shocks: Some Theory 203 Policy Response to Inflation 207 Policy Response to Balance of Payments Deterioration 214 Contents vii Policy-Induced Crises 219 Conclusions 220 Part Three Policy Trends and Long-Run Growth Chapter 9. Fiscal Policy 225 Overview of Public Finances 225 Fiscal Policy: Stabilization and Adjustment 231 Longer-Run Fiscal Policy and Growth 234 The Sustainability of Public Deficits and Current Account Deficits 235 Fiscal Policy and Long-Run Growth 240 Appendix 242 Chapter 10. Monetary Policy 244 Monetary Policy-Objectives and Instruments 244 Monetary Policy and Macroeconomic Crises 248 Monetary Policy and Stabilization 249 Monetary Policy and Long-Run Inflation 254 Monetary Policy and Growth 254 Government Finance, Financial Liberalization, and Monetary Policy 255 Overall Assessment 256 Appendix: A Model of Inflation 257 Chapter 11. Trade and Payments Policy 264 Some Terminological Preliminaries 264 Overview of Trade and Payments Policies and the Underlying Political Economy 266 Capital Controls 271 Trade Intervention 272 Exchange Rate Policy 274 Concluding Remarks 281 Appendix: Estimated Demand and Supply of Exports 284 Chapter 12. The Deficits and Surpluses of the Public and Private Sectors 294 Household Saving 294 Corporate Saving 301 Public Saving 301 The Financing of Public Investment 305 The Sustainability of Public Deficits 310 Summary 311 viii India. Macroeconomicsand Political Economy.1964-1991 Chapter 13. Investment and Growth 313 The Relationship between Public and Private Investment 315 The Distribution and Instability of Public Sector Investment 318 The Efficiency of Investment 319 Explaining a Rise in the Growth Rate of GDP 327 Summary 329 Appendix 329 Chapter 14. Concluding Remarks 342 The Dichotomy of Macroeconomics and Microeconomics 342 Macroeconomic Consequences of the Control Regime 343 The Fiscal Problem 346 A Summary of What We Believe 350 Appendix A. The Quality of Economic Statistics 353 Statistics Available for Macroeconomic Management 353 National Income Statistics 356 Appendix B. StructuralistMacroeconomics and the Indian Economy 359 Notes 363 Bibliography 379 Index 391 List of Tables 1.1 Sources of Saving, 1980-81 16 1.2 Employment in the Organized Sector 19 1.3 GDP from Public Sector, by Industry 20 1.4 Public Investment and Savings 21 1.5 Different Tax Proportions Collected by Center and States 23 1.6 Current Government Expenditure (CGE) of Center and States 24 3.1 Indicators of Unrest, 1971-78 54 3.2 Real Fixed Investment before and after 1979/80 61 4.1 Commitments and Disbursements of Aid, 1961/62 to 1969/70 77 4.2 Selected Macroeconomic Indicators 81 4.3 Consolidated Government Current Expenditure, 1964/65 to 1970/71 87 4.4 Gross Fixed Capital Formation (GFCF) in the Public Sector, by Industry, 1960/61 to 1970/71 88 Contents ix 4.5 Public Gross Fixed Capital Formation (GFCF), by Level of Authority, 1964/65 to 1970/71 89 4.6 Growth Ratesof Gross Fixed Capital Formation and GDP, 1961/62 to 1970/71 90 4.7 Summary Monetary Indicators, 1962/63 to 1970/71 91 4.8 Real Wages in Agriculture and Organized Manufacturing, 1960/61 to 1970/71 92 4.9 Foodgrain Availability, 1961-70 96 4.10 Output and Price Indicators, 1961/62 to 1970/7l 97 4.11 Monetary Indicators. 1960/61 to 1970/71 99 4.12 Fiscal Indicators: Consolidated Government, 1960/61 to 1970/7l 100 4.13 Investment and Saving, 1960/61 to 1970/71 101 4.14 Real Gross Fixed Capital Formation, 1960/61 to 1970/7l 102 4.15 India's Balance of Payments, 1960/61 to 1970/71 103 5.1 Annual Changes in Foodgrain and Agricultural Production, 1970/7l to 1978/79 107 5.2 Aid Disbursements, 1961/62 to 1973/74 107 5.3 Export Prices, Import Prices, and the Terms of Trade, 1970/71 to 1978/79 108 5.4 Indicators of Expansion, 1967/68 to 1972/73 /I1 5.5 Terms of Trade Shock, 1973/74 to 1975/76 I14 5.6 Fiscal Deficits and Fiscal Impulse, 1970/71 to 1975/76 117 5.7 Money and Reserve Money, 1971/72 to 1976/77 117 5.8 Real Wages in Agriculture and Organized Manufacturing, 1970/71 to 1979/80 120 5.9 Percentage Changes in Real Per Capita Incomes, 1972/73 to 1975/76 121 5.10 Wholesale Price Index, 1973/74 to 1978/79 124 5.11 Foodgrain Availability, 1970-78 129 5.12 Output and Price Indicators, 1970/71 to 1978/79 130 5.13 Monetary Indicators, 1970nl to 1979/80 131 5.14 Fiscal Indicators: Consolidated Government, 1970/71 to 1978/79 132 5.15 Investment and Saving, 1970/71 to 1978/79 133 5.16 Real Gross Fixed Capital Formation.