Deepak Mohanty: Indian economy - progress and prospects
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Harvard Business School, Boston, 27 September 2011.
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The assistance provided by Dhritidyuti Bose and Abhiman Das is acknowledged.
It is an honour and privilege for me to be speaking at Harvard to such a distinguished
audience. I thank Professor Benjamin Friedman and Professor Tarun Khanna for this
opportunity. I will be speaking on the Indian Economy.
India is home to 1.21 billion people, which is about 17.4 per cent of the global
population. However, it accounts for only 2.4 per cent of world GDP in US dollar terms and
5.5 per cent in purchasing power parity (ppp) terms. Hence, there exists a huge potential for
catch up. The global welfare too is linked to progress in India as reflected in the keen global
interest in India. But, India seems to inspire and disappoint at the same time. This is reflected
in various comments on the Indian economy. Yasheng Huang and Tarun Khanna in their
much debated article in July 2003 issue of Foreign Policy had observed: "Can India surpass
China? This is no longer a silly question". The July 23rd 2011 issue of The Economist
observed; "Twenty years ago they said the yardstick against which India should be measured
was its potential. On that measure, there is much to do."
As a fledgling democracy, India's economic experiment of planned development was
held out as an example to many aspiring low-income countries in the 1950s. While some
countries raced ahead in the development process, India lagged behind. This is evident from
the fact that it took 40 long years from 1950-51 for India's real per capita GDP to double by
1990-91. But, 1991-92 was a defining moment in India's modern economic history as a
severe balance of payments (BoP) crisis prompted far reaching economic reforms, unlocking
its growth potential. As a result, in only 15 years, India's per capita income doubled again by
2006-07. If the current pace of growth is maintained, India's per capita income could further
double by 2017-18, in 10 years time. While acceleration in India's recent economic growth is
noteworthy, maintaining the pace, no doubt, will be challenging.
Against this background, I propose to highlight the key policy reforms since 1991-92,
review the economic progress made so far and then conclude with some reflections on policy
challenges in the way forward.
Policy reforms post-1991
Macroeconomic crisis of 1991 marked a turning point in India's economic history for
two reasons. First, fiscal deficit driven external payment crisis with a dip in foreign exchange
reserves to below US$ 1 billion in July 1991 drew a crisis resolution strategy to restore
macroeconomic stability. Sharp correction in fiscal deficit-GDP ratio and reduced
monetisation of deficits contributed towards restoring macroeconomic balance by the
mid1990s. The reduced dependence of fisc on monetisation enabled the Reserve Bank of India
to reduce its statutory pre-emption of funds from banks, thereby freeing resources for the
private sector. Second, simultaneously efforts were made towards wide ranging structural
reforms encompassing areas of trade, exchange rate management, industry, public finance
and the financial sector.
An abiding objective in respect of industrial policy measures since then has been to
create a competitive environment to improve productivity and efficiency. New industrial policy
fostered competition by abolishing monopoly restrictions, terminating the phased
manufacturing programmes, freeing foreign direct investment and import of foreign
technology and de-reservation of sectors hitherto reserved for the public sector. These
measures created a favourable environment for industry to upgrade its technology and
buildup its capacity through imports in order to cater to growing domestic and external demand.
At present, only five industries are under licensing, mainly on account of environmental,
health, safety and strategic considerations. Only two industries are reserved for the public
sector, viz, atomic energy and railway transport. Reservation of industrial products for the
small scale sector is still a lingering issue. However, the definition of small scale industry
(SSI) has been changed to facilitate modernisation and now only 20 items are reserved for
manufacturing in the small scale sector. Foreign Direct Investment (FDI) up to 100 per cent is
allowed under the automatic route in most sectors, with a few exceptions.
The infrastructure sector has been thrown open to the private sector. Considering the
large requirements of funds for infrastructure, 100 per cent FDI has been allowed in all
infrastructure sectors. There are extended tax holidays to enterprises engaged in the
business of development, operation, and maintenance of infrastructure facilities. The
emphasis has been on public-private partnership (PPP) as one of the preferred modes for
infrastructure project implementation.
Comprehensive fiscal reforms covered tax reforms, restructuring of public sector
undertakings and improving fiscal-monetary coordination before eventually carrying these
reforms forward under rule based fiscal consolidation path from 2004-05, which was
interrupted by the global financial crisis in 2008-09. Reduction in customs duties over the
years reflected India's commitment towards converging towards the ASEAN levels over the
medium-term.
The monetary policy framework and the associated operating procedures of monetary
policy in India have evolved over time with the changes in the underlying macroeconomic
structure and development of financial markets. A landmark development was the abolition of
the system of automatic monetisation of fiscal deficit from April 1997, which provided
instrument independence to the Reserve Bank of India in the conduct of monetary policy.
This, combined with the introduction of auctioning system in the government securities,
enabled the Reserve Bank to switch from direct to indirect instruments of monetary control.
With the opening up of the economy and deregulation of the financial sector, the
stability of money demand function became suspect. The Reserve Bank, therefore, switched
from a monetary targeting framework, adopted in the mid-1980s, to a multiple indicator
approach. Under this approach, various indicators such as rates of return in different
markets, movements in currency, credit, fiscal position, trade, capital flows, inflation rate,
exchange rate, refinancing and transactions in foreign exchange - available on a high
frequency basis - are juxtaposed with output data for drawing policy perspectives. This
approach continued to evolve and is presently in its augmented version, wherein forward
looking indicators drawn from the Reserve Bank's industrial outlook survey, capacity
utilisation survey, professional forecasters' survey and inflation expectations survey are used
for macroeconomic assessment. The operating procedure of monetary policy also underwent
a change with the overnight interest rate emerging as the operating target of monetary policy.
In the financial sector, the objective was to provide operational flexibility and functional
autonomy to banks and other financial institutions so that they could allocate resources more
efficiently. Some of the important initiatives in the financial sector were: reduction in statutory
preemptions so as to release greater funds for commercial lending, interest rate deregulation
to enable price discovery, allowing new private sector banks to create a more competitive
environment, dilution of government holding in public sector banks and institution of
prudential norms such as capital adequacy, income recognition, asset classification,
provisioning and exposure norms to strengthen the health of the banking system besides
improving transparency and disclosure standards.
The development of financial markets has been regarded as a critical prerequisite for
improving the operational effectiveness of the transmission of monetary policy. During the
first phase of financial sector reforms, various structural rigidities were eased, so as to
increase participation in financial markets as well as develop and strengthen inter-linkages
amongst market segments, and foster competition. The focus of various reform measures in
financial market was on ensuring adequate liquidity in various segments of the market
spectrum, and developing the regulatory, legal, institutional and technological infrastructure
for orderly functioning of market activity. In the second phase of reforms, more sophisticated
financial instruments were introduced. Further, issues relating to the stability of financial
markets received priority in the policy agenda.
The key objective of the external reforms was to move to a more open trade regime by
correcting for the implicit anti-export bias. Moreover, there was a greater recognition of the
need to view trade policies, exchange rate policies and industrial policies in an integrated
manner. In pursuance of this, the administered exchange rate regime gave way to a flexible
market-determined system. The exchange rate has since been guided by underlying demand
and supply conditions and the broad principles of careful monitoring and management of
exchange rates with flexibility, without a fixed or preannounced target or band.
The trade policy reforms comprised withdrawal of the quantitative restrictions on
exports and imports, phasing out of the system of import licensing and lowering the level and
dispersion of nominal tariffs so as to bring them on par with the East Asian economies. The
peak customs tariff rate was progressively brought down from 150 per cent in 1991-92 to
10 per cent by 2008-09. The liberalization of restrictions on various external transactions led
to current account convertibility under Article VIII of the Articles of Agreement of the IMF
in 1994.
With respect to capital account liberalization, India embarked on a gradual and well
sequenced opening up of the capital account. The active capital account management
framework was based on a preference for non-debt creating capital inflows like foreign direct
investment and foreign portfolio investment. The capital account is virtually free for
nonresidents and resident corporates with some restrictions on financial institutions and higher
restrictions on resident individuals.
Economic progress post-1991
The initiation of economic reforms in the 1990s saw India gradually breaking free of the
low growth trap which was euphemistically called the "Hindu growth rate" of 3.5 per cent per
annum. Real GDP growth averaged 5.7 per cent per annum in the 1990s, which accelerated
further to 7.3 per cent per annum in 2000s. A feature of the growth acceleration during the
period was that while the growth rate of industry and services increased that of agriculture
fell. This was because there was no notable technological breakthrough after the "green
revolution" of the mid-1960s which saw sharp increase in yields of cereal production
particularly in northern part of India. By the 1990s, the momentum of "green revolution" had
died down. Consequently, the yield increases in the 2000s were much lower than those
experienced even in the 1990s.
Notably, the decade of the 2000s encompassed the inflexion point in the growth
trajectory with an annual average GDP growth of about 9 per cent for the 5-year period
2004-08. Growth in all the sub-sectors of the economy, including agriculture, accelerated
during this period. However, this growth process was interrupted by the global financial crisis.
Subsequently, the average growth slowed down to 7.8 per cent during 2009-11 with a
noticeable slow down in both agriculture and industry.
The growth dynamics altered the structure of the Indian economy with a decline in the
share of agriculture from 28.4 per cent in the 1990s to about 15 per cent in 2009-11. There
was corresponding gain in the share of services, including construction, from 52 per cent to
65 per cent during the same period. What is, however, of concern is that the share of
industry has remained unchanged at around 20 per cent of GDP. This suggests that India's
growth acceleration during the last two decades has been dominated by the services sector.
The pace of average annual industrial growth had nevertheless picked up from 5.7 per cent
during the 1990s to 9 per cent during 2004-08 before being interrupted by the global
financial crisis (Table 1).
While the share of industry in GDP remained stagnant, there was noteworthy structural
transformation in manufacturing over the period. As a process of restructuring, while the
gross value added in organized manufacturing increased by 8 per cent per annum at current
prices, employment fell by 1.5 per cent per annum during 1995-2003. Subsequently, during
2004-09 gross value added growth accelerated to 20 per cent per annum at current prices;
but significantly, employment also increased by 7.5 per cent per annum.
With work participation rate of 39.2 per cent, India had a workforce of 400 million in
2009-10. Of this, 53 per cent was in agriculture and the rest 47 per cent in non-agricultural
activity. While the bulk of the employment is in agriculture despite its shrinking share, the
noteworthy feature of the employment structure has been that for the first time the absolute
workforce in agriculture declined in the latter half of the 2000s (Table 2). The overall
unemployment rate in the economy also declined from 8.3 per cent in 2004-05 to
6.6 per cent in 2009-10.
Not surprisingly, the growth acceleration was accompanied by a sharp pick-up in the
rate of growth of gross fixed capital formation which had more than doubled from an annual
average of 7.2 per cent in the 1990s to 15.7 per cent in the high growth phase of 2004-08. It,
however, has dropped significantly in the post-crisis period to 5.8 per cent (Table 1).
The structure of Indian economy also underwent a change during this period in terms
of openness. The stereotypical view that India is a closed economy has not been borne out
by the openness of Indian economy which was increasing rapidly. Exports and imports of
goods and services have more than doubled from 23 per cent of GDP in the 1990s to
50 per cent in the recent period of 2009-11. If the trade flows are considered alongside
capital flows, the rise in openness (measured as current receipts and payments plus capital
receipts and payments) was more dramatic from 42 per cent of GDP in the 1990s to
107 per cent in the recent period (Table 3) Empirical evidence suggests that with increasing
openness of the Indian economy, the trade and industrial cycles were getting more
synchronised with the global business cycle.
The high growth phase of 2004-08 was accompanied by sharp increase in exports and
imports as well as capital inflows. Net capital inflows as percentage of GDP more than
doubled from 2.2 per cent in the 1990s to 4.6 per cent of GDP during 2004-08.
Subsequently, growth rates in both trade and capital inflows moderated following the global
financial crisis. The openness of the Indian economy has been accompanied by
improvement in India's external position as the debt to GDP ratio fell from about 29 per cent
in the 1990s to 19 per cent in the recent period. The debt service ratio has also declined from
25 per cent to under 5 per cent during the period (Table 4).
The openness in the capital account has resulted in two-way movement in capital with
a sharp pick-up in India's outward FDI since the mid-2000s (Table 5). Uptrend in outward FDI
mainly reflected the large overseas acquisition deals of Indian corporates to gain market
share and reap economies of scale amidst progressive liberalisation of the external
payments regime.
Gradual improvements were also observed in the fiscal position with fiscal deficit
moderating sharply during the high growth phase of 2004-08, which also coincided with a
period of switch over to a rule based fiscal consolidation process. In fact, the high growth
phase of 2004-08 saw a primary surplus for the Centre enhancing debt sustainability. The
deficit indicators, however, have deteriorated in the recent period following crisis induced
fiscal expansion (Table 6).
The average saving rate also showed a substantial increase from 23 per cent of GDP
in the 1990s to about 31 per cent in the 2000s with a peak saving rate of over 33 per cent
achieved during the high growth phase of 2004-08. Fiscal consolidation helped in lifting the
overall saving rate as public sector saving rose significantly. The efficiency of capital
utilisation also improved as the incremental capital output ratio (ICOR) declined to 3.7 during
the high growth phase of 2004-08 from 5 in the 1990s. Subsequently, however, capital
efficiency has declined in the post-crisis period (Table 7).
The high growth was achieved in an environment of price stability as headline
wholesale price index (WPI) inflation dropped to an annual average of 5.5 per cent in the
2000s from 8.1 per cent in the 1990s. There was also similar drop in consumer price
inflation. Subsequently, however, in the post-crisis period the inflation trend has reversed
with the headline WPI inflation averaging over 7 per cent and the consumer price inflation
crossing double digits during 2009-11. The uptick in food price inflation was particularly
sharp during 2009-11 (Table 8).
During this period, financial deepening of the Indian economy has also increased:
broad money (M3) to GDP ratio rose from an average of 50 per cent in the 1990s to
85 per cent in the recent period of 2009-11. Credit penetration, measured as credit to GDP
ratio, also increased from 21 per cent of GDP to about 50 per cent during this period. The
high growth phase of 2004-08 was accompanied by acceleration in growth of bank credit to
the private sector to about 27 per cent per annum from about 15 per cent in the 1990s.
However, during the high growth phase of 2004-08, the average increase in M3 remained
contained which aided price stability. This was made possible due to deceleration in banks'
investment in government securities to about 13 per cent per annum during 2004-08 from
21 per cent in the 1990s. Fiscal consolidation opened up the space for private credit
expansion without exerting much additional pressure on monetary expansion (Table 9).
Policy challenges
The draft approach paper for the Twelfth Five Year Plan (2012-17) released in August
2011 targets an annual GDP growth rate of 9 per cent. This is challenging but not
unattainable. Why? Because India has already achieved an average growth rate of about
9 per cent during 2004-08 which was interrupted by the global financial crisis. Subsequently,
average growth has dropped by about one percentage point to 7.8 per cent during 2009-11.
In 2011-12, the terminal year of the Eleventh Plan, growth is expected to be about
8 per cent. Hence, growth will have to be raised by an additional percentage point per annum
which is challenging because it will require a conducive global environment and policy
reforms at home. While there are several tasks to be addressed, I will focus on six key
issues.
First, India will have to raise agricultural productivity and diversify agriculture to feed its
own population. The food entitlement has increased with the public employment guarantee
programme (MGNREGA) which guarantees for 100 days of employment to one member of
each family in the rural areas. This has also given better bargaining power to labour and
consequently the overall wage rates have gone up raising the demand for food. While the
country currently has sufficient foodgrains stocks, it is not yet self-sufficient in pulses and
oilseeds. Further, demand for protein based products like meat, egg, milk and fish as well as
fruits and vegetables has increased substantially with rise in income. The demand-supply
mismatches in the case of these items have resulted in rise in their prices. There is,
therefore, a need for another technological breakthrough to give fresh impetus to agriculture.
At the same time, greater emphasis will have to be placed in the management of supply
chain with investment in rural infrastructure. The annual growth in agriculture has to be
raised to at least 4 per cent from the current trend growth rate of around 3 per cent.
Second, the fact that 53 per cent of overall work force is still engaged in the agricultural
sector - whose share of GDP has shrunk considerably - is worrisome. A substantial part of
this labour force will have to be ejected from agriculture not only to improve the productivity
in agriculture but also in the overall economy. It is unconceivable that they can all be
absorbed gainfully in the services sector. Hence, industrial employment will have to expand
so also the relative contribution of industry. This needs a focused attention as we have seen
that the share of industry in the overall GDP has stagnated over the last two decades. In this
direction, the Government has taken up a major policy initiative to create National
Manufacturing and Investment Zones (NMIZ) to increase the sectoral share of manufacturing
in GDP to 25 per cent by 2022 and double the current employment level in the sector. Good
physical infrastructure, a progressive exit policy, structures to support clean and green
technologies, appropriate investment incentives, and business friendly approval mechanisms
will be the cornerstones of this new initiative.
Third, to support industrialization and increased economic activity, there is a need to
step up investment in infrastructure. The assessment of the Planning Commission suggests
an investment of '45 trillion (US $ 1 trillion) over the Twelfth Plan (2012-17). Given the large
requirement of long-term funds, financing infrastructure would be a big challenge. Besides
budgetary support, the bulk of the funds has emanated from banks. However, channelling
domestic and foreign financial savings of this scale into infrastructure will require developing
the domestic private corporate debt market. Apart from the need for substantial financial
outlays for infrastructure, there are several non-financing constraints: particularly land
acquisition delays need to be addressed to avoid time and cost overruns.
Fourth, there is a need for the Government to revert to its rule-based pre-crisis fiscal
consolidation path without compromising on the quality of fiscal correction. This is necessary
to obviate the risk of twin deficits and to raise the overall saving rate. This will require further
reform in the tax structure to ensure revenue buoyancy and greater focus on quality of
expenditure with an emphasis on reduction of subsidy. In this regard, major reforms in the
pipeline are the introduction of an integrated Goods and Services Tax (GST) by the Centre
and the States to reduce cascading effect and improve tax compliance and operationalisation
of a Direct Taxes Code (DTC), to improve allocative efficiency and equity of the direct taxes.
Fifth, credit markets have, historically, played a crucial role in sustaining growth
through efficient intermediation of funds between savers and investors. Although India has a
well-diversified financial system, and several measures for financial inclusion have been
taken in the recent past, credit penetration continues to be relatively low in comparison with
several other developed and emerging market economies. The extent of financial exclusion
is staggering with around 61 per cent of population having a deposit account and only
10 per cent of population having a credit account. The Reserve Bank has embarked on a
plan of making available basic banking services to all habitations of population of over 2000
by 2012 through a combination of brick and mortar branches and a system of business
correspondents (BCs). Accelerated economic growth will depend on access to formal finance
by the bulk of the population and greater credit penetration.
Sixth, empirical evidence suggests that the threshold level of inflation is in the range of
4-6 per cent. Hence, without bringing inflation down from the current level it will be difficult to
sustain a high level of growth. This will require greater monetary-fiscal coordination and
alleviation of supply constraints, particularly in agriculture.
Conclusion
Envisioning India's emergence as a major economic power in the world, Dr. Manmohan
Singh in his Union Budget 1991-92 speech that launched wide ranging economic reforms
had quoted Victor Hugo's saying, "no power on earth can stop an idea whose time has
come". Ever since, there has been no looking back as India launched wide ranging structural
reforms and has made significant economic progress over the past two decades. India's
industrial environment has become more competitive and open, infrastructural gaps have
been sought to be bridged through public-private initiatives with both domestic and foreign
sources of funding, current account has become fully convertible while capital account is
virtually free for non-residents. The policy environment has become more enabling with
rulebased commitment on fiscal policy and considerable instrument independence for operation
of monetary policy. As statutory preemptions were reduced and interest rates were
deregulated, banks gained operational autonomy for commercial lending. As a result, India's
per capita income, which had taken four decades to double by 1991, doubled thereafter in
15 years and is likely to double again in 10 years by 2017-18. If India could maintain the
current pace of growth it will lift millions out of poverty and enrich the global economy. While
India has come a long way, maintaining the current pace would itself be challenging and
require continued reform efforts.