Rakesh Mohan: Economic reforms in India - where are we and where do we
go?
Lecture by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at a Public Seminar
organized by the Institute of South Asia Studies, Singapore, 10 November 2006.
Views expressed are personal.
* * *
We have now had a decade and a half of economic reforms. It is perhaps appropriate at this point to
stand back and take stock of what we have done as we venture further. Today I shall, therefore, make
an effort to (a) review what has been done; (b) evaluate where we are; and (c) suggest where we need
to go.
Let me give you the backdrop as to what motivated me to choose this topic. I recently came across,
The Tipping Point: How Little Things Make a Big Difference, by Malcolm Gladwell. He observes that
many large changes sometimes happen in a hurry. Whereas there is usually a step by step, gradual
process of little changes taking place, an epidemic suddenly acquires a tipping point and spreads
suddenly. I believe that at the present juncture we are in need of such an epidemic of change and
growth; we are perhaps at the tipping point. The macro-foundations of a healthy environment have
been laid and now we need lots of little things to make a big difference.
I. What has been done
What has been the main objective of the overall economic reform process in India, or for that matter,
anywhere? The primary objective has to be the overall acceleration of economic growth along with
rapid elimination of poverty. The means to achieve these objectives would be the injection of
competition in the economy in order to induce greater efficiency and productivity gains; and dedicated
efforts are needed to build capacity through human resource development.
Let me begin with a broad brush of history. Around 50 to 100 years before our independence in 1947,
there was hardly any discernible economic growth in the whole Indian sub-continent. Per capita
income was stagnant, perhaps declining over that whole long period. After independence, annual per
capita growth broke out of this long period of slumber and was in the range of 1 to 1.5 per cent for
about 30 years or so until around 1980. After 1980 it increased to about 3-4 per cent, which was a
major departure in our recorded history. Along with this change, a good deal of new thinking also took
place in terms of the strategy for future economic policy. As it happened, there was a full blown
economic crisis at the end of the 1980s: the balance of payments came under severe pressure, and a
realistic threat of sovereign default loomed over us; fiscal deficits had increased significantly over the
1980s; and inflation began to creep up to the late teens. These unfortunate developments focussed
our minds like never before: India has a proud history of never ever having defaulted on our
international objections; our fiscal management has historically been conservative; and inflation
seldom exceeded 10 per cent.
Consequently, a whole reform process got unleashed in 1991.
I will first give a brief run-down of the various reforms that have taken place in the last 15 years before
providing some evidence of their effectiveness. For expository convenience I shall make a conceptual
difference between (a) macroeconomic reforms and (b) microeconomic reforms.
Macroeconomic reforms and fiscal stabilisation
Over a period of time through the 1950s, 1960s, and 1970s the economy had become over controlled
and rigid; consequently entrepreneurship was heavily constrained. The import substituting inward
looking development strategy that could have been relevant in the 1950s and 1960s was no longer
suitable in the modern globalising world. Hence overall reform had to be undertaken to lay down a new
framework. Wide ranging macro reforms were undertaken along with corresponding microeconomic
and sectoral reforms. The macro reforms can be divided into (a) fiscal policy, (b) monetary policy, (c)
trade policy, and (d) exchange rate management. Without any claim of exhaustiveness, the exposition
aims at setting the context.
Fiscal system
The tax system, both for direct and indirect taxes, had become very complex in India. Maximum
marginal personal income tax rates were high, along with a number of rates for different income
ranges. The corporate tax rate was high too. Accordingly, the tax code had to be riddled with a number
of special provisions for exemption of different kinds of income, and the corporate tax code was full of
exceptions and incentives. Because of high rates and complexity, avoidance and evasion was
naturally high. As a consequence, over the whole reform period, both the personal income tax and
corporate tax rates have gradually been brought down to 30 per cent, along with considerable
simplification.
Similarly, in the case of indirect taxes, there were high levels of both domestic excise duties and
customs tariffs, with a myriad of rates for different commodities. Again, this necessitated a whole
range of specific provisions and exemptions for different kinds of producers and end uses, leading to
great administrative complexity. A major programme of comprehensive and continuous reform has had
to be undertaken over the last 15 years. The rates in case of customs duties have been brought down
from an average of 110 per cent in 1991 (with highs over 400 percent) to a non agricultural peak of
12.5 per cent in 2006. There has been massive simplification of the excise tax structure to achieve a
"central" rate (CENVAT) of 16 per cent (apart from a few exceptions like food products, textiles and
some optical fibres that attract lower tax rates). Excise, which is levied at the manufacturing stage, is
now essentially levied as a VAT (Value Added Tax) so that cascading is avoided. In addition, the
service tax has been introduced in order to tax the whole economy more fairly and to reduce the
excessive burden on one sector, the manufacturing sector. Such tax reforms typically take a long time.
The latest most significant measure taken is the introduction of the Fiscal Responsibility and Budget
Management Act (FRBM) in 2004, which enjoins the government to eliminate its revenue deficit and
reduce its fiscal deficit to 3 per cent of GDP by 2009. Similar acts have been passed by most state
governments (23 states so far). So fiscal responsibility has now become part of our legislative
commitments. The other most noteworthy development at the federal level is the transformation of
state level sales taxes to the Value Added Tax (VAT), which has introduced a large measure of
rationality and uniformity in the state tax system. The state sales tax system had also suffered from
great complexity in terms of multiplicity of rates and special provisions. A vital feature of this tax reform
has been the consultative process among all the states as mediated by the central government, which
then resulted in this consensus for massive reform.
Overall, the fiscal reform process spanning both the central and state governments over the last 15
years has been truly wide ranging.
Monetary policy
Over the 1970s and 1980s, monetary policy, as we know it, had become almost non-existent: with a
system of credit allocation, administered and different interest rates for different purposes; automatic
monetization of fiscal deficits; and financial repression through pre-emption of banks' resources.
Hence a number of measures had to be taken. These include: elimination of automatic monetization,
reduction of statutory pre-emption of the lendable resource of banks, and interest rate deregulation. As
a result of these measures independence of monetary policy and the central bank has been restored.
There was a consequent movement from direct to indirect instruments of monetary policy. These
changes in the practice of monetary policy are manifest in its effectiveness in the significant reduction
of inflation. In fact, if one bifurcates the period since independence into two, one from the early 1950s
to late 1990s, and the other since the late-1990s to present day, then there is marked difference in the
average inflation rates between the two periods. While it was around 7-8 per cent during the first forty
five years, it has fallen to around five per cent in the recent period since the late 1990s.
External sector reforms
It was the balance of payment crisis in 1991 that was the key trigger for reforms. Consequently,
actions on the external sector have been of the greatest importance. Despite the existence of
comprehensive quantitative trade restrictions along with high levels of tariffs, the balance of payments
was under continuous pressure through the 1960s, 1970s and 1980s. Consequently, exogenous
shocks such as oil price rises, or monsoon failures, invariably led to large crises necessitating
recourse to IMF resources. With the existence of these trade restrictions, the exchange rate was
typically overvalued over a long period of time. Hence, among the first reform moves was an ex ante
real devaluation of the exchange rate in 1991 and a move of the exchange rate regime from that of a
crawling peg towards a market determined one, though somewhat managed.
The trade regime has undergone massive change with the removal of quantitative restrictions along
with rationalisation of the tariff structure. There has been a massive reduction in the number of tariff
rates and the peak rate of tariff has been reduced from around 400 per cent to 12.5 per cent for
nonagriculture products. Tariff reform for agriculture products has been constrained by the intransigence
of developed countries in reducing their farm subsidies. Internationally, India has always participated
actively in WTO negotiations. More recently, reflecting the hiccup in the achievement of consensus for
further global trade reforms, India has also began to participate in a number of regional and bilateral
trade agreements that are in the making.
With the change in the exchange rate regime and accomplishment of trade reforms the current
account is now open along with limited capital account convertibility. The exchange rate regime
focuses on management of volatility without a fixed rate target and the underlying demand and supply
conditions determine the exchange rate movements in an orderly way.
Micro economic reforms
Let me now turn to the micro economic reforms. Industrial deregulation, infrastructure reforms,
financial sector strengthening, capital market deepening and agriculture are the major areas where
such reforms have taken place.
Industrial policy
Massive deregulation of the industrial sector, in fact, constituted the first major package of reforms in
July 1991. The obsolete system of capacity licensing of industries was discontinued; the existing
legislative restrictions on the expansion of large companies were removed; phased manufacturing
programmes were terminated; and the reservation of many basic industries for investment only by the
public sector was removed. At the same time restrictions that existed on the import of foreign
technology were withdrawn, and a new regime welcoming foreign direct investment, hitherto
discouraged with limits on foreign ownership, was introduced. With this massive reform introduced in
one stroke in 1991, the stage was set for a policy framework that encouraged new entry, introduced
new competition, both domestic and foreign, which thereby induced the attainment of much greater
efficiency in industry over a period of time. One area of industrial reform that has been sluggish has
been the removal of restrictions that exist on investment in most labour using industries - known as
small scale industry reservations. In 1991 as many as 836 industries were reserved for investment by
only small firms, defined by the level of investment. The number of these industries has now come
down to 326.
Infrastructure
A number of measures have been initiated in the development of infrastructure since 1996. Many of
India Infrastructure Report
these reforms emanated from the recommendations of the of the mid
1990s. We recognized that infrastructure investment had to be raised and suggested introduction of
the private sector in infrastructure which had been restricted earlier. This was part of a world wide
move during the 1990s. This has also necessitated other wide ranging reforms including new
legislations and formation of regulatory authorities.
With deregulation, introduction of the private sector and formation of the Telecom Regulatory Authority
of India (TRAI), telecom is indeed a success story. The major reforms in roadways were: imposition of
a fuel cess to finance highway construction; the commissioning of the National Highway Development
Gram Sadak Yojana
Project and PMGSY (Prime Minister's or the Rural Roads Programme). In case of
ports private operators have been introduced and then the Tariff Authority of Major Ports (TAMP)
formed; in civil aviation new private airlines, new private airports and the beginning of an open skies
policy are in evidence. In all these cases the response has been positive.
In other infrastructure sectors, the reform process experience has been mixed. In the power sector,
where some of the early efforts for reform were made in the early 1990s, problems continue to
constrain its expansion. A comprehensive modern electricity act has been enacted, which has
enabling features for encouraging private sector entry, enhanced competition, and rational regulation.
However, despite the formation of a central regulatory authority and others at the state level,
implementation of the tariff reform has not been found to be easy. State Electricity Boards continue to
suffer from losses, arising both from inadequate tariff and from transmission and distribution losses
(comprising important part of theft). Consequently, private sector investors in power generation face
insecurity of payment and hence expansion of private investment in this sector has been constrained.
Although the Act allows for private participation in distribution, practically it has not been found easy to
privatize distribution systems. Thus, power reforms have some way to go, although the legislative and
institutional pre-requisites are now in place.
Urban infrastructure is another area where reform has been inadequate and thinking has just begun.
In transportation, considerable reforms have taken place in air and road transportation but railways
have some way to go. Although there has been noted improvement in financial performance of
railways in the last couple of years, there is need for much greater structural reforms for this vital
transportation system to be put in a sound sustained growth path.
Financial sector
Financial sector reform is another area of India's success story. A major element of the financial sector
reform was the introduction of competition enhancing measures. Introduction of operational autonomy
and partial disinvestment of public ownership in public sector banks, entry of new private and foreign
banks and permission for FDI and portfolio investment in banking are some the major reform
measures in this area. Listing of almost all public sector banks is another major reform in this regard.
Besides, prudential regulations have been strengthened in line with Basel I standards and are now in
process of being updated to Basel II standards. An effort has been put in for phased implementation of
international best practices such as, CRAR, provisioning and income recognition norms, exposure
limits and measures to strengthen risk management.
The introduction of partial private sector ownership in public sector banks and their consequent listing
has been extremely important for market orientation of these banks and transparency in their accounts
and operations. This gradual process of banking sector reforms has contributed significantly to the all
round improvement in the financial health of the banking system.
Among other segments of the financial sector, new private insurance companies have been introduced
with limited foreign ownership. Subsequent to insurance nationalization in the 1950s and 1960s, all
insurance was in the public sector, with just one life insurance company and four general insurance
companies. The introduction of new competition has led to the introduction of new products and new
practices. A new regulator, the Insurance Regulation and Development Authority (IRDA) has been
formed to govern the insurance industry.
The capital market has been revived with both policy reforms and financial infrastructure development.
The Securities and Exchange Board of India was formed as the capital market regulator; a new
modern technology oriented stock exchange was formed (the National Stock Exchange, NSE); private
sector mutual funds allowed and encouraged; along with the abolition of the Controller of Capital
Issues (CCI) who controlled both issuance of securities and administered their price. A particular
development has been the building of world class payment and settlement architecture in the stock
market and government securities market. The one area that still needs considerable attention and
development is the corporate bond market.
Agriculture
Agriculture is the key significant area that has not been subject to comprehensive reforms. It is not
widely understood, though, that the reduction of industrial tariffs improved the domestic terms of trade
significantly for agriculture. In terms of trade reforms in agriculture, these have been constrained by
the lack of progress in the WTO and the intransigence of developed countries in the reduction of their
farm subsidies. There have, however, been a number of significant reforms: removal of restraints on
inter state movement of foodgrains; the restructuring of the public distribution system (PDS); relaxation
of restrictions under the Essential Commodities Act; introduction of forward trading in most agricultural
commodities; and removal of some marketing restrictions on crop produce. There is no doubt,
however, that agricultural development needs much more focused attention in order to revive the
somewhat stagnating agricultural economy.
Having given a bird's eye view of the reforms measures let me now turn to the outcome of this whole
wide ranging reform process.
II. Where are we?
There is a need to remember where India was at the time of its independence. Power capacity was
just 1.1 per cent of what it is now. The country was literally in darkness! With high mortality rates, the
average Indian died at age 32. More than half of the country was under the poverty line. The income
of an average household is now nearly Rs.130,000. Poverty was down to 23-26 per cent in
19992000. Per capita growth has gone up from about 1.5 per cent per year in the first 30 years after
independence to about 6.4 per cent per year now. This makes a palpable difference in peoples'
standard of living (Tables 1, 2 and 3).
Having outlined the major elements of India's achievement since independence let me briefly review
the broad trends in various macro-policy variables.
The step-up in the growth rate of the economy has been facilitated by increase in domestic investment
to over 30 per cent of GDP, financed predominantly by domestic savings. Domestic savings increased
to over 29 per cent of GDP by 2004-05 after some stagnation in the second half of the 1990s. The
improvement in overall savings in recent years has particularly benefited from the turnaround in public
sector savings. After turning negative between 1998-99 and 2002-03 owing to sharp deterioration in
the savings of Government administration, public sector savings have turned positive again from
200304 onwards, mainly reflecting the ongoing fiscal consolidation. In 2004-05, the public sector savings
rate was 2.2 per cent, but it was still less than a half of the peak of almost five per cent touched in
1976-77. Improvement in corporate profitability since 2002-03 has also contributed to increase in
domestic savings in the recent years. Household savings remain the predominant component of
domestic savings, contributing almost three-fourths of overall domestic savings in 2004-05. For the
Indian economy to achieve higher growth on a sustained basis, further improvement in overall savings
is necessary and, in this context, public sector savings will have to play a significant role (Table 4).
Fiscal performance has still some way to go. The gross fiscal deficit has come down from 7 per cent in
1993-94 to 4.1 per cent in 2005-06. However, this needs to go to 3 per cent by 2009. Tax Revenue
has just recovered to 10 per cent of GDP, about the 1991-92 level, and needs much greater growth
(Table 5). Inflation is down from the 45 year average of 7 - 8 per cent to 4.5 - 5.0 per cent. So we have
achieved some major macro and monetary improvements. However, growth needs investment and
savings. Although the growth process stuttered somewhat in the late 1990s and early part of this
decade, it has clearly recovered now and we seem to be on a sustainable path of annual GDP growth
in excess of 8 per cent. After the award of the Pay Commission in 1997, public finances had come
under strain and hence public savings had become negative. This was also accompanied by a
business cycle slowdown and low profitability in the private corporate sector and low corporate
savings. Both recoveries have now taken place: public sector savings are now again positive; and
corporate profitability is also very healthy. With continuing growth in household savings, gross
domestic savings are now 30 per cent plus and hence sustained investment rates in excess of 32 per
cent are feasible. The sustenance of a higher growth now needs improvement in public investment
and delivery of public services.
Financial sector reforms in general and banking reforms in particular have been a key ingredient of the
Indian reforms process. As a result of these reforms, statutory pre-emptions of banks (in the form of
high cash reserve and statutory liquidity ratio) got reduced to a great extent - so was the extent of
financial repression. Interestingly the asset quality of the Indian banks has improved to a great extent
with a distinct improvement in capital-to-risk adjusted assets ratio (CRAR) of banks which is much
above the stipulated level (9 per cent), and drastic reduction in NPA levels, notwithstanding the
transition to 90-day delinquency norm in 2004 (Table 6). The initial recapitalization by government in
the public sector banks has been rather meagre (about 1 per cent of GDP) which was supported by
equity issuance by the public sector banks. With public listing the public sector banks in India are now
more subject to market discipline. Furthermore, there has been a distinct improvement in post-reform
productivity as reflected in various indicators such as, business per employee, profit per employee and
branch productivity. These productivity gains can be attributed to both technological improvement as
well as peer pressure or catching up effect.
Let me briefly touch on the external sector now. The measures taken in respect of the external sector
have clearly been very successful. Merchandise exports have increased from 6 to 13 per cent of GDP
between 1990-91 and 2005-06; imports have also increased from 10 to 24 per cent of GDP over the
same period; foreign exchange reserves increased from $ 1.5 billion to $ 165 billion.
Industrial growth was very high during the 1992-97 period in the immediate exuberance of industrial
policy reforms. However, there was a significant slowdown during 1997-2002. As tariffs were reduced,
import controls were lifted, and domestic competitive threats emerged at the same time, the initial
protective effects of the ex ante real devaluation of 1991 wore off and the Indian corporate sector,
particularly in manufacturing, found itself in difficulty. The Indian corporate sector was therefore in the
throes of significant technical restructuring, business process restructuring and financial restructuring,
all at the same time. It can be said in retrospect that, though this process resulted in an industrial
slowdown then, it has contributed to the industrial competitive resurgence that is now observed. There
is a revival of manufacturing. A competitive company can be found in almost every sector industrial
sector now. As indicators of this competitiveness, exports are growing more than 20 per cent; and the
balance of payments with reference to China is almost even (Table 7).
The performance of the Indian corporate sector has been highly encouraging in the last three years.
The previous occasion, when such a healthy performance was demonstrated by the corporate sector
was in the early 1990s, i.e., during the initial period of exuberance immediately after the economic
reforms programme was initiated in India. But during the latter part of the 1990s, around 1997, the
momentum in the corporate sector slowed down in sync with the general economic slowdown. The
recovery since then is remarkable in all important parameters: sales, gross profit, profit after tax, all
have recorded robust growth rates during 2002-03, 2003-04 and 2004-05 implying that economic
activity in the corporate sector has taken a full circle after three years of dull performance during
1999-2000, 2000-01 and 2001-02 (Table 8).
The current exuberant run of corporate sector performance has continued well into its fourth year as
evidenced by the corporate sector results for the first quarter of 2006-07. The strong sales
performance has resulted in an improved bottom-line for the corporate sector as a whole. Powered by
a strong top-line performance, gross profits of the Indian corporate sector grew at a sturdy rate of 34
per cent in the quarter ending in June 2006 on top of a 20 per cent growth recorded in the full fiscal
year of 2005-06. The interest costs have been plummeting in the recent years due to an overall
softening of interest rates and lower debt equity ratios, which is an outcome of conscious policy-driven
measures.
There is in fact a new confidence in the air. Let me give some random illustrations - TISCO is the
lowest cost steel producer, Hindalco / Sterlite / NALCO are competitive aluminum producer, Reliance
is a major petrochemical producer. We now have world class producers in most sectors and there are
many more success stories. Moser Baer exports more than Rs.1000 crore; Hero Honda with 1.7
million motor cycles is the largest producer of motor cycles; one now gets a wide range of automobiles
in India such as Maruti, Tata, Hyundai, Toyota, GM, Ford; in Pharma there are Ranbaxy and Dr
Reddy's among others; Bharat Forge exports castings and forgings to all main auto producers;
Sundaram Clayton has been adjudged as Best GM supplier.
Let me sum up the broad contours of success of the overall economic reform programme. In general,
the reform programme has achieved remarkable success. Annual GDP growth has averaged 6 to 6.5
per cent during the whole 15 year period since reforms began, and is now ascending to a higher
trajectory of 8 per cent plus sustained growth. The external sector is comfortable: gone are the days of
perpetual "shortage" of foreign exchange. In contrast, some observers view India's foreign exchange
as reserves as a problem of plenty. Industrial growth has been restored and the manufacturing sector
has found a new level of competitiveness, quality and efficiency. There is a transformation in the
external impression of the Indian economy: it is now viewed with a sense of some awe and confidence
in its potential of sustainable high growth. Finally, measured poverty has been reduced significantly.
But we still have miles to go. The poverty ratio of 23-26 per cent is still too high, about a quarter billion
people living in poverty are too many. Employment growth is inadequate and we have an expanding
young labour force, which will demand quality jobs. Public service delivery continues to be poor, with
little sign of improvement.
Let me now turn to a menu of things that we need to do.
III. Where do we go?
We have now had 15 years of economic reforms spanning five governments. What have these
reforms achieved? We have ascended a higher growth path; poverty has been reduced; the external
sector is more than comfortable; industrial growth has been restored; and all this has been achieved
with financial stability in the country. As a consequence of all these momentous changes there is a
new respect for India in the world and, even more important, Indians in all walks of life have found a
new level of self confidence.
But we still have miles to go. We need to move to the next level of sustained growth so that per capita
income growth can exceed seven per cent per annum (or over 8.5 per cent per GDP growth per
annum on a sustained basis) and thereby see at least a doubling every decade. Although poverty has
been reduced considerably to less than 25 per cent, this level is still too high with 250 million living
under the defined poverty line, which itself is at a very low level.
The main organizing principle of most reforms carried out so far has been that of freeing the private
sector from the myriad government controls that had existed for a long time. Whereas this process
itself still has some distance to go, the consequence of this widespread deregulation and introduction
of competition in most segments of the economic sphere has been the very visible unleashing of
entrepreneurial energies at all levels and in most parts of the country. We have been reasonably
successful in what we set out to do so far, with the benefits of increased competition and efficiency
manifesting themselves in the higher recorded growth, particularly in the present decade.
The issue that arises now is whether we have reached the limit of private sector led acceleration in
investment and output growth? Will this now be increasingly constrained by the lack of public
investment, both physical and social? An underlying theme encompassing most constraints now is the
lack of adequate delivery of public services in both quality and quantity. The public service system is
simply not functioning.
Further acceleration in economic growth and reduction of poverty will need greater investment and
employment growth along with enhancement of productivity. For such acceleration to take place we
will need a significant enhancement of growth in capacity building and in the availability of public
services that the private sector cannot provide.
I, therefore, believe that just as the first generation of reforms empowered the private sector to perform
as it can to the limits of its abilities, the second generation of economic reforms must focus on a similar
empowerment of the public sector to deliver public goods and services for the benefit of all segments
of the private sector, corporate entities and the public alike. Lest this proposition be misunderstood, it
should be made clear that I am not advocating greater empowerment of the public sector to increase
its control over the economy as was the case in the past. The "public sector" needs to be seen in its
widest definition to encompass all levels of governments from the local, state to national, and their
entities, which deliver public goods and services.
I would like to take up four areas, by way of illustration, where we need to give focused attention and
which I believe can mainly be done by the public sector, even if some of it is to be delivered through
public private partnership.
The four areas that I propose to address are: agricultural development, urban development, human
resource development, management of public services.
What is common among these sectors is the lack of competence in public systems that govern these
areas. There are other areas of broader governance that could also be taken up, particularly the
maintenance of law and order, but that would take me too far a field from my area of competence
related to the economy.
Agriculture
One of the most disturbing features of the recent growth experience has been that of the deceleration
in agriculture growth (Table 9).
With about 60 per cent of the population still largely dependent on agriculture, this deceleration has
clearly had a significant impact on slower reduction in poverty levels than otherwise would have been
the case. Moreover, for aggregate annual GDP growth to exceed 8.5 per cent on a sustainable basis it
will be difficult if agricultural growth itself does not exceed 4 per cent annual growth. The fast growing
economies of East and South-East Asia all exhibited elevated levels of agriculture growth along with
industrial and service sector growth during their fast grow