at the Crossroads SUSTAINING GROWTH AND REDUCING POVERTY ©International Monetary Fund. Not for Redistribution This page intentionallyleft blank ©International Monetary Fund. Not for Redistribution at the Crossroads SUSTAINING GROWTH AND REDUCING POVERTY EDITED BY Tim Callen Patricia Reynolds Christopher Towe INTERNATIONAL MONETARY FUND ©International Monetary Fund. Not for Redistribution 2001 International M netary Fund © o Production: IMF Graphics Section Cover design: Lai Oy Louie Library of Congress Cataloging-in-Publication Data India at the crossroads p. em. ISBN 1-55775-992-8 (alk. paper) 1. India--Economic policy--1980. 2. India--Economic conditions--1947- 3. Fiscal policy--India. 4. Sustainable development--India. HC435.2 .1484 2001 330.954--dc21 00-054132 Price: $2 7.00 Address orders ro: External Relations Department, Publication Services International Monetary Fund, Washington D.C. 20431 Telephone: (202) 623-7430; Te lefax: (202) 623-7201 E-mail: [email protected] Internet: http:l/www.imf.org ©International Monetary Fund. Not for Redistribution Contents Page Foreword . vii Acknowledgments . ix Overview 1. Christopher Towe 1 PART I. Preserving External Stability India and the Asia Crisis 2. Christopher To we . 11 3. Assessing India's External Position Tim Callen and Paul Cashin . 28 PART II. Fiscal Challenges 4. Tax Smoothing, Financial Repression, and Fiscal Deficits in India Paul Cashin, Nilss Olekalns, and Rama Sahay . 53 5. Fiscal Adjustment and Growth Prospects in India Patricia Reynolds . 75 PART III. Monetary and Financial Sector Policies Modeling and Forecasting Inflation in India 6. Callen . 105 Tim The Unit Trust of India and the Indian Mutual Fund 7. Industry Anna Ilyina . 122 ©International Monetary Fund. Not for Redistribution vi CONTENTS PART IV. Growth, Poverty, and Structural Policies 8. Growth Theory and Convergence Across Indian States: A Panel Study Shekhar Aiyar .................................. 143 9. Structural Reform in India Daniel Kanda, Patricia Reynolds, and Christopher Towe ... 170 List of Contributors ................................... 191 ©International Monetary Fund. Not for Redistribution Foreword India is a Land of contrasts. One billion people Live in a vast territory among architectural and sculptural wonders that give vivid testimony to its ancient and rich history, as well as to its powerful and age-old cus­ toms. Yet, there is also a very modem face of India, which is responding to the growing forces of globalization and where information technology has found a fertile environment. These contrasts and the force of tradition appear to have contributed to a cautious approach to change. Tentative and slow moving attempts to free the economy from pervasive controls were started in the 1980s, but it was not until the serious balance of payments and macroeconomic crisis of the early 1990s that India introduced significant and wide­ ranging policy reforms. These reforms are widely considered to have been successful in promoting a marked improvement in macroeconomic performance. Nevertheless, the subsequent pace of reform has been Less even and bold, and the question remains whether the basis has been laid for the sustained and rapid growth that wiLL be necessary to alleviate the deep poverty that still afflicts more than a third of the population. That India emerged relatively unscathed from the financial crisis that affected most of Asia as well as many emerging economies is testimony to the country's resilience. Many sectors of the economy-and above all the information technology sector-have shown extraordinary dyna­ mism and remarkable vitality. At the same time, India is roday at a cross­ roads and a number of macroeconomic indicators display worrisome trends. In particular, the fiscal situation has worsened in recent years and requires concentrated and determined attention to reduce the risk of fi­ nancial instability. Fiscal consolidation in combination with more rapid pace of structural reform, liberalization, and infrastructure development is also necessary to lay the foundation for strong growth. The chaLLenge for the government is to forge a political consensus across a diverse range of interest groups that is necessary to sustain rapid and consistent reform on broad range of fronts. The chapters in this volume seek to address the implications of these challenges and opportunities. For the most part, they were written during vii ©International Monetary Fund. Not for Redistribution viii FOREWORD 1999-2000 in the context of the lMF staff's ongoing policy discussions with India. By bringing these issues together in a single volume, the macroeconomic and structural challenges that are highlighted can be given greater prominence and thus contribute to the policy debate, both in India and, more broadly, in other reform-oriented economies. MARIO BLEJER I. Senior Advisor Asia and Pacific Department ©International Monetary Fund. Not for Redistribution Acknowledgments The papers included in this volume were largely prepared in the con­ text of the IMF's Article IV consultation discussions with India during 1999-2000, under the leadership of Mario I. Blejer. His support and en­ couragement during this process are gratefully acknowledged. The pa­ pers also benefited from comments received fromDr. V. Kelkar, IMF Ex­ ecutive Director; his Advisor, Dr. N. Jadhav; and from the staff of the Reserve Bank of India and the Indian Ministry of Finance. The authors would also like to thank Mary Abraham and Irene Aquino for their infi­ nite care and patience in preparing the manuscripts, and Alex Hammer and Aung Thurein Win for their research assistance. Sean M. Culhane, of the IMF's External Relations Department, edited the volume and was masterful in guiding it to completion. The views expressed in this book are those of the authors, and do not necessarily represent those of the Indian authorities, IMF Executive Di­ rectors, or other IMF staff. ix ©International Monetary Fund. Not for Redistribution This page intentionallyleft blank ©International Monetary Fund. Not for Redistribution 1 Overview CHRISTOPHER TOWE India's macroeconomic performance during the past decade has in many respects been remarkable. Since the early 1990s, India has been among the fastest growing economies in the world, inflation has been relatively well contained, and the balance of payments has been main­ tained at comfortable levels. This performance was achieved despite poor weather that caused negative agricultural growth in fiscal year (FY) 1995/96 and again in FY 1997/98, the Asian financial crisis in 1997 and 1998, international sanctions imposed on India and Pakistan following tests of nuclear devices in 1998, and the considerable volatil­ ity in world oil and commodity prices that occurred in 1998-2000.1 Much of India's economic strength during the early and mid-1990s can be ascribed to the broad-ranging fiscal and structural reforms un­ dertaken following the 1991 balance of payments crisis. These included reforms to the tax system, substantial cuts in the deficit of the consoli­ dated public sector, liberalization and deregulation in the industrial sec­ tor, trade and tariff reforms, and measures to recapitalize and strengthen the supervision of banks and other financial intermediaries. These poli­ cies helped spur a strong recovery, with real GOP growth accelerating to an average of 7 percent in the mid-1990s from as low as of 1 per­ Y4 \12 cent at the beginning of the decade. Although economic activity slowed somewhat in subsequent yea�s, it remained relatively robust, especially when compared with the other emerging markets that were buffeted by the Asian financial crisis. Dur­ ing the last two years of the 1990s, growth averaged 6\12 percent, as 1The Indian fiscal year begins on April 1. 1 ©International Monetary Fund. Not for Redistribution 2 OVERVIEW agricultural output recovered strongly from poor weather in late 1997 and industrial production rebounded in response to the turnaround in agricultural incomes and the recovery elsewhere in the region. India's inflation performance has also been relatively favorable-inflation gen­ erally trended downward during the 1990s, reaching as low as 3112 per­ cent by FY 1999/00. Following the 1991 crisis, India's balance of payments also strength­ ened. Indeed, in the latter half of the decade, despite the effect of the regional crisis on merchandise exports, the current account deficit began narrowing. The deficit fell to less than 1 percent of GOP in FY 1999/00, partly reflecting the impact of India's growing exports of information technology (IT)-related services. Although inward portfo­ lio and foreign direct investment were hurt by the erosion of interna­ tional market sentiment in 1997 and 1998, other private inflows were maintained, and with the recovery in international investor sentiment in FY 1999/00, India's foreign exchange reserves reached $38 billion by March 2000, a gain of almost $12 billion from three years earlier. By the end of the decade these favorable macroeconomic trends con­ tributed to growing optimism about India's longer-term growth prospects. Indian equity prices strengthened enormously, benefiting from the global boom in IT stocks, and private sector fo recasters steadily revised upward their projections for GOP growth to 7 percent or more. This optimism carried over to the political arena, with the new govern­ ment elected in late 1999 setting a growth target of 7-8 percent over the medium and longer terms-recognizing the importance