Rakesh Mohan: Indian economy in the global setting
Address by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the 99th Foundation
Day Celebration Function of the Indian Merchants' Chamber, Mumbai, 8 September 2005.
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I am extremely happy to be here in this at 99th Foundation Day Celebration Function of the
Indian Merchants' Chamber at Mumbai on 8 September, 2005. Indian Merchants Chamber
has a long heritage - and I wish them all the best for this year's celebrations and next year's
centenary. In this age of globalization, I thought it would be apposite to share with you an
account of India's place in the global economy. Where do we stand? Have we improved our
performance? These are some of the issues that I will attempt to delve in the present
address.
In the recent decade, India along with China has emerged as the engine of global growth.
This is well reflected in India's share in world GDP increasing significantly from 4.3 per cent
in 1991 to 5.8 per cent in 2004. This period has also been one when India initiated structural
reforms which encompassed, inter alia, a phased opening up of the Indian economy to the
external sector. These structural reforms have strengthened India's external sector and have
also imparted a degree of dynamism to the Indian economy. The opening up of the Indian
economy has not only allowed it to reap benefits of globalisation but India is also contributing
to global growth. Against this backdrop, I discuss India's recent economic growth record in
order to draw lessons for it to realize its potential in a globalised world.
Recent economic growth: overview and issues
Economic developments in the recent years indicate a growing resilience of the Indian
economy. Illustratively, even as the Indian economy was buffeted by exogenous shocks
emanating from a below normal monsoon and record high international oil prices, overall
GDP growth was almost 7 per cent during 2004-05. Effective macroeconomic management
during the year ensured that India remained one of the fastest growing economies among
emerging market economies in an environment of macroeconomic and financial stability.
Looking at the post-reform period, real GDP growth has stepped up from 5.8 per cent per
annum during the 1980s to 6.2 per cent per annum between 1992-93 and 2004-05. Over the
same period, per capita growth has recorded a more impressive increase from 3.4 per cent
to 4.3 per cent.
Structural reforms have increased the competitiveness of the Indian industry and this is
reflected quite vividly in the robust merchandise export growth since 2002-03 - exports have
grown (in US $ terms) by more than 20 per cent per annum in each of the last three years.
Concomitantly, the services sector contributes more than one-half of GDP, with growing
contributions from new impulses of growth such as the information technology,
telecommunication and transport sectors and a revival of foreign tourist arrivals.
A noteworthy feature of macroeconomic management is the success with maintaining price
and financial stability. Inflation has averaged close to five per cent per annum since the
second half of the 1990s, significantly lower than that of around seven to eight per cent in the
previous three and a half decades. This was possible due to effective monetary
management, enabled by reforms in the fiscal-monetary interface. This has had a soothing
influence on inflation expectations. Thus, despite poor monsoon conditions, record
international crude oil prices and sharp increases in a host of non-oil commodity prices,
inflation could be contained at around 5 per cent by the end of fiscal 2004-05, reflecting
effective calibrated monetary measures supported by timely supply-side and fiscal measures.
Inflation in the current year so far has eased to 3.1 per cent, although it needs to be
recognised that the pass-through of international oil prices to domestic oil prices remains
incomplete. We may also note that unlike previous oil price rise episodes of international
inflation has also been contained this time.
Another notable feature of the post-reform period is the improvement in the health of the
financial sector. Reforms in the financial sector introduced since the early 1990s have had a
major impact on the overall efficiency and stability of the banking system, reflected in
improvements in capital adequacy ratios and strengthening of the balance sheets.
Furthermore, Indian banks have done a remarkable job in containment of NPLs considering
the overhang issues and overall difficult environment. Net NPAs have now fallen to just two
per cent of net advances.
The external sector continues to be robust. Despite sharp increase in oil as well as non-oil
imports, India's balance of payments has recorded large and persistent surpluses, with
foreign exchange reserves at around US $ 144 billion. Increased earnings from exports of
services and remittances coupled with enhanced foreign investment inflows have provided
strength to the external sector.
In brief, the Indian economy has exhibited a strong performance since the early 1990s in an
environment of macroeconomic and financial stability - higher GDP growth, lower inflation, a
resilient external sector and a strong financial sector. All these happened during the 1990s,
which was otherwise a turbulent decade in terms of financial instability in many other
countries. Nonetheless, it is widely agreed that the growth of the Indian economy remains
well-below its potential. Real GDP growth in the first three years (2002-03 to 2004-05) of the
Tenth Plan period has averaged 6.5 per cent, lower than the Tenth Five Year Plan
(20022007) target of eight per cent per annum. While the economy is doing well in many areas and
these gains need to be consolidated, there are also important weaknesses, which, if not
corrected could undermine even the potential performance level. In this context, it is
interesting to note that the recent years (2001-02 to 2003-04) have seen India recording
surpluses in the current account, i.e., we have not been able to find investment avenues to
deploy our domestic savings. It is, therefore, important that impediments to investment be
removed so that domestic savings can be deployed at home. Of course, to realise the growth
potential of 8-9 per cent of the Indian economy, domestic savings will have also to record
commensurate increases. Reforms would have to be further intensified in the agricultural
sector, in factor markets to promote flexibility, in bankruptcy and exit procedures, in fiscal
consolidation and in physical and social infrastructure sectors to accelerate investment. I will
address some of these issues next.
Although the poverty ratio has declined since the onset of the reforms process, the number
of people below the poverty line still remains high, with wide variations across states.
Between 1977-78 and 1999-2000, the proportion of people living below the poverty line fell
from 51.3 per cent to 26.1 per cent; over the same period, the absolute number of poor
people fell from about 330 million to about 260 million, a number that is still sizable. In
200103, for instance, India's per capita income was equivalent to only 9 per cent of the global
average and 2 per cent of the per capita income of the high income countries.
With more than half of the people still dependent on agriculture, a key area of concern is that
agricultural growth remains low and continues to be monsoon-dependent. Growth in the
agricultural and allied sectors has decelerated from 3.2 per cent per annum during 1980-96
to 1.9 per cent subsequently. Per capita agricultural GDP has shown no significant upward
trend after 1996-97. The slowdown is wide-spread across crops and reflects a broad based
deceleration in productivity growth. The deceleration in output coincided with a downturn in
world prices, and this has impacted domestic farm prices more than in earlier decades
because of greater openness. The consequence has been that farm incomes became more
variable and decelerated more than output in many cases.
A related cause of concern, given that 57 per cent of population is still agricultural
dependent, is that the role of agriculture in providing additional employment opportunities
was virtually zero during the 1990s. Employment in agriculture remained virtually unchanged
at about 190 million people during the 1990s. Concomitantly, annual employment growth for
the economy, as a whole, decelerated from two per cent during the 1980s to only 1.1 per
cent in the latter half of the 1990s. With employment growth trailing the additions to the
labour force, unemployment rate for the economy as a whole is estimated to have increased
from 8.87 per cent in 2001-02 to 9.11 per cent in 2004-05, a proportion that is far too high for
a country like ours. The generation of productive employment is, therefore, a key issue that
needs to be addressed on a continuous basis.
The slowdown in the agricultural sector reflects subdued public investment in agriculture and
inadequate crop diversification. A step-up in public investment in rural infrastructural areas
such as irrigation, rural electrification and rural roads will become possible through reduction
in and better targeting of subsidies that would then enable greater public investment for
promoting growth. Efforts are also needed to diversify the cropping pattern to non-traditional
activities in line with the changing agricultural demand pattern and making use of recent
advances in bio-technology. The process of diversification calls for micro-level planning with
emphasis on crop specific inputs, creating proper marketing infrastructure, cold storage,
transportation facilities and supportive policies. There is a need for value addition in
agricultural products through processing, packaging, and supply chain management so that
farm incomes expand, employment is generated and rural poverty is alleviated. Other
initiatives to increase agricultural production could cover aspects such as better availability of
commodity derivatives to minimize the impact of prices uncertainty; reducing
monsoondependency through schemes like water harvesting; and, further augmenting the flow of
credit to the rural sector. Diversification of agriculture would also provide stable additional
avenues of employment generation in the rural sector and enable these sectors to emerge as
the main source of growth and employment in rural areas. All these measures will promote
competitiveness of the agricultural sector, which is so necessary in the current global
context.
As regards social sector indicators, notwithstanding some progress in regard to education
and health, India is still far behind its East Asian neighbours. Our social indicators are lower
even in comparison with the levels achieved by these countries twenty five years ago, when
they first began to grow rapidly. The social indicators also show disturbing gender gaps,
large rural-urban differences and wide variation across states. Although the literacy rate has
improved encouragingly from 52.2 per cent in 1991 to 64.8 per cent in 2001 and the overall
number of illiterates in the country declined from 329 million in 1991 to 306 million in 2001,
there are at least seven major States with more than 15 million illiterates each, accounting for
nearly two-third of total illiterates in the country. Concomitantly, given India's comparative
advantage in services, it is important that the quality of secondary and higher education in
the country is improved so that adequate skills are developed to realize the benefits of the
knowledge economy. As regards health, the combined government (Centre plus States)
expenditure on health as a percentage of GDP has stagnated at around one per cent of GDP
over the last decade and a half. Total public expenditure on health in India remains even
lower than many other developing countries such as Brazil (3.4 per cent), Thailand (2.1 per
cent), Sri Lanka (1.8 per cent), China (1.9 per cent) and Malaysia (1.5 per cent). Low public
expenditure in India is to some extent compensated by private expenditure which at 4.0 per
cent of GDP is comparatively higher than all of these countries except Brazil (4.9 per cent).
However, low public expenditure is a cause for concern for the vast majority of the population
and primary health care remains of poor quality, unavailable and inaccessible. The infant
mortality rate in India is almost double that of China (63 in India versus 37 in China) while the
maternal mortality rate at 407 is manifold as compared to China's 56. Hospital beds (per
1000 population) at 0.7 for India are less than one-half of other developing economies such
as China (2.4), Thailand (2.0) and Malaysia (2.0). A significant improvement in social
indicators is necessary if we want to create the pre-condition for a general improvement in
welfare of our population and for genuine equality of opportunity.
Turning to the industrial sector, reforms which encompassed removal of industrial licensing,
de-reservation, substantial opening of foreign direct investment and trade liberalisation have
imparted a competitive edge to Indian industry. This is reflected in a resurgence of activity in
the manufacturing sector in the past two years, and the present phase appears to be
sustainable, in contrast to the exuberance - which turned out to be temporary - reflected in
high growth in investment and production in industry during 1993-94 to 1996-97. For
industrial activity to get entrenched and gather momentum, efficiency in supply of
infrastructural inputs will need a large impetus. The subdued performance of the
infrastructure sector in the recent months is an issue of concern, given the sector's strong
forward and backward linkages in the economy. The increasing demand-supply gap in the
availability of power is becoming the most critical issue in the future of India's economic
development. In the recent period, shortage of coal and gas has emerged as a serious
constraint on power generation with the supply of both fuels falling far short of demand. In
this context, given the fact that the Indian economy is among the more inefficient users of
energy, highest and urgent priority needs to be given for energy-saving measures, which
could include appropriate pricing policies and incentives to invest.
With growing urbanisation, issues related to urban infrastructure have come to the forefront.
At present, investment in urban infrastructure is hampered by the fact that local governments
are not yet creditworthy and urban infrastructure projects are, therefore, not found to be
commercially viable. Strengthened planning and better coordination between various
agencies entrusted with maintenance of urban infrastructure would have a positive impact on
the overall productivity of economic activity in cities. Given the fact that there is a heavy
concentration of economic activity in large cities, weak infrastructural facilities impede the
growth of large cities and of overall economic productivity. It is, therefore, of the utmost
importance that the quality of urban infrastructure in the large cities is improved significantly
so as to maintain and accelerate the momentum of economic growth and productivity
enhancement. For urbanising economies like India to replicate the experience of developed
countries in the provision of urban infrastructure, it is essential that all aspects of city
management, including the fostering of a professional workforce, are strengthened.
The maintenance of vibrant growth in the manufacturing sector will depend crucially on the
expansion of small and medium enterprises that then become significant players in the
future. For this potential to be realized, there is a need to increase credit availability to this
sector at reasonable costs. Banking institutions need to improve their credit assessment
capabilities with regard to small-scale enterprises and small-scale must not be equated with
high risk. Recent initiatives of the government and the Reserve Bank, such as the new
legislation aimed at developing credit information bureaus will help to reduce information and
transaction costs that should then lead to lower cost of credit to the SSI sector. Empirical
evidence shows that wider availability of credit histories greatly expands the flow of credit as
potential borrowers are no longer tied to their local lenders.
The services sector has emerged as the largest contributor to growth in the country.
Advances in information technology, liberalisation of the telecommunications sector and
availability of skilled labour have permitted India to reap advantages through the globalisation
of some services. The initial impetus provided by exports of software and services has now
got additional support from the exponential growth of the IT-enabled sector (ITES). According
to the National Association of Software and Service Companies (NASSCOM), India's
software and service exports recorded a strong growth of 34 per cent in 2004-05. The
software sector [including ITES-Business Process Outsourcing (BPO)] now employs more
than one million people, having recorded a compounded annual growth of nearly 30 per cent
in employment during the period 1999-2005. The software sector also provides indirect
employment to 2.5 million people. These data bring forth the growing role of the software
sector, but at the same time, they suggest that for this order of growth rates to be maintained
in the future, investment in social infrastructure - especially, education - needs to
steppedup. In this context, it is necessary that public expenditure on education should reverse its
declining trend: total expenditure by the State Governments on education is budgeted to
decline from 2.5 per cent of GDP in 2003-04 to 2.3 per cent in 2005-06. Moreover, given the
demographic profile, the demand for education is slated to increase further. Accordingly, the
improvement in State finances will enable the States to increase their expenditure on
education and other social services and thereby improve the quality of overall social
infrastructure so that India can realise its potential.
It is now well-recognised that monetary policy can contribute to long-run growth by
maintaining low and stable inflation. International experience indicates that a prudent fiscal
policy remains the single largest prerequisite for monetary stability. In India, reforms in the
monetary-fiscal interface during the 1990s have been a key factor that imparted greater
flexibility to monetary policy. These reforms have taken a significant step forward with the
enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 by the
Centre. With the Centre's GFD/GDP ratio at 4.1 per cent in 2004-05 (provisional accounts),
the FRBM target of 3.0 per cent by 2008-09 appears to be within striking distance. However,
with revenue deficit at 2.7 per cent in 2004-05, the elimination of the revenue deficit by
200809 will prove to be more difficult. Achieving this target requires continued focused action on
containing expenditures, increase in tax revenues and reduction in tax exemptions. Revenue
augmentation would critically depend upon improvement in tax/GDP ratio as non-tax revenue
is set to decline in the coming years. With the acceleration in overall economic growth that is
being observed currently, renewed efforts on tax compliance should yield beneficial results.
Achievement of the FRBM target of revenue deficit at zero per cent of GDP will free up
resources for public investment which will also crowd-in private investment. Overall, despite
the recent improvements in the fiscal position of the Central Government the effort in
achieving fiscal consolidation will have to continue.
International crude oil prices are touching a record high. In previous episodes of such high oil
prices, India often faced balance of payments crisis, low growth and high inflation. In the
most recent period, the economy has been able to absorb the oil shock relatively comfortably
so far. However, in case international oil prices continue to remain at the existing elevated
levels, they could have a negative influence on growth prospects internationally. It is
important to note that oil intensity - oil consumption per unit of output - in India has
increased since early 1970s in contrast to the behaviour of major economies such as the
Euro area, the US and Japan. Although oil intensity in India is still lower than that of
advanced economies, there is scope for adopting measures to enhance efficiency of oil use
in the economy. Energy conservation measures in the backdrop of high and volatile
international crude oil prices could help the Indian economy to weather the adverse
consequences with relatively lower output losses. In this context, there is a need for policies
that permit flexibility in domestic oil prices that respond to the ups and downs in international
prices, albeit with some mechanism that cushions the impact on the common man. This will
also enable more efficient use of oil in the economy, especially in view of the fact that the rise
in international oil prices appears to have a large permanent component.
Given the volatility in the inflation rate during 2004-05, there is a need to consolidate the
gains obtained in recent years from reining in inflationary expectations. While sustained
efforts over time have helped to build confidence in price stability, inflationary expectations
can turn adverse in a relatively short time if noticeable adverse movements in prices take
place. Credible commitment of policy to fight inflation is critical to stop translation of higher oil
prices into wage-price spirals. In addition, the international prices of non-oil primary
commodities may continue to remain firm. On the domestic front, the manoeuvrability on oil
prices is getting limited and corporates have a higher probability of gaining their pricing
power with a better industrial outlook. The pricing pressure, if it were to occur from the supply
side, could get complicated by continuing overhang of excess domestic liquidity. While the
economy has the resilience to withstand supply shocks, the upside risks do exist. As such,
the inflationary situation, both international and domestic, needs to be watched closely to
persevere in maintaining inflation expectations and any complacency on this count could
have adverse consequences for both stability and growth.
Global economic integration
With the growing external openness of the Indian economy, and given its pace of expansion
and size, the debate in the recent period is not only on the contours of the public policy in the
context of increasing global economic integration but also to the challenges likely to be faced
by the global economy on account of progressively increasing global integration of the Indian
economy. The emphasis is of course on successful integration which will no doubt depend
on the appropriateness of our public policies and the private sector responses. These issues
are addressed next.
Globalization has several dimensions arising out of enhanced connectivity among people
across national borders. In particular, economic integration occurs through three channels,
viz., movement of people, of goods and, of finance or capital. In managing the process of
economic integration, developing countries face challenges from a world order that is
particularly burdensome on them. It is necessary for public policy to manage the process with
a view to maximizing the benefits to its citizens while minimizing the risks; but the path of
optimal integration is highly country-specific and contextual. On balance, there appears to be
a greater advantage in achieving a well-managed and appropriate integration into the global
process, which would imply more effective - but not necessarily intrusive or extensive -
interventions by governments. In fact, while there are some infirmities in interventions by
government, markets do experience market-failures and cannot exist without some externally
imposed rules and prescriptions of the public policy. As the poor, the vulnerable and the
underprivileged continue to be the responsibility of the national governments, there is
relevance of national public policy - particularly as it relates to global economic integration.
Against this backdrop, external sector policies designed to progressively open up the Indian
economy, as observed earlier, formed an integral part of the strategy for structural reforms.
In this context, the Report of the High Level Committee on Balance of Payments (Rangarajan
Committee, 1993) recommended improvement in exports, both merchandise and invisibles;
modulation of import demand on the basis of the availability of current receipts to ensure a
level of current account deficit consistent with normal capital flows; enhancement of non-debt
creating flows to limit the debt service burden; adoption of market-determined exchange rate;
building up the foreign exchange reserves to avoid liquidity crises and elimination of the
dependence on short-term debt. It is evident that the external sector policies of the 1990s,
based on the Report, paid rich dividends in terms of growth and resilience to a series of
external and domestic shocks.
Various reforms in the trade policy regime have unlocked entrepreneurial energies, stepped
up productivity gains and improved competitiveness and access to overseas markets. India's
merchandise exports have been rising at a rate of over 20 per cent per annum, in US dollar
terms, during 2002-05. As a result, the secular decline in India's share in world exports from
two per cent in 1950 to 0.5 per cent in the 1980s has been reversed. This share began rising
in the 1990s and is currently at 0.8 per cent. These positive developments in the external
sector provide the environment of pursuing a further rationalisation of tariffs with a view
towards moving to a single, uniform rate on imports, say 10 per cent, and simplify all customs
procedures strictly in line with best global practices. This should help to improve competition,
exports and domestic consumers. The current external environment including the level of the
foreign exchange reserves enables such a move to be made with little or no downside risks.
While the recent trend in imports may continue to persist in the face of high and volatile
crude prices and the large increase in domestic demand, an intrinsic link between
merchandise imports and exports has emerged and become entrenched. The large
expansion in imports is also spurring vigorous export growth. Given the recent experience,
especially the fact that workers remittances seem to have acquired a semi-permanent, if not
permanent, character, the current level of the trade deficit appears to be manageable at this
stage and appears to be consistent with India's growth aspirations.
Given the adverse international experience with unfettered capital account liberalisation, we
have been risk averse and have adopted a policy of active management of the capital
account. The compositional shifts in the capital account have been consistent with the policy
framework, imparting stability to the balance of payments. The sustainability of the current
account is increasingly viewed as consistent with the volume of normal capital flows. The
substitution of debt by non-debt flows also gives us room for manoeuvre since debt levels,
particularly, external commercial borrowings, have been moderate and can be raised in the
event of a sustained pick up in the demand for external resources. There is also the cushion
available from the foreign exchange reserves.
India has made significant progress in financial liberalisation since the institution of financial
sector reforms in 1992 and this has been recognised internationally. India has chosen to
proceed cautiously and in a gradual manner, calibrating the pace of capital account
liberalisation with underlying macroeconomic developments, the state of readiness of the
domestic financial system and the dynamics of international financial markets. Unlike in the
case of trade integration, where benefits to all countries are demonstrable, in case of
financial integration, a 'threshold' in terms of preparedness and resilience of the economy is
important for a country to get full benefits. A judgmental view needs to be taken whether and
when a country has reached the "threshold" and the financial integration should be
approached cautiously, preferably within the framework of a plausible roadmap that is drawn
up by embodying the country-specific context and institutional features. The experience so
far has shown that the Indian approach to financial integration has stood the test of time.
The optimism generated by the recent gains in macroeconomic performance warrants a
balanced consideration of further financial liberalisation. At this stage, the optimism
generated by impressive macroeconomic performance accompanied with stability has given
rise to pressures for significantly accelerating the pace of external financial liberalisation. It is
essential to take into account the risks associated with it while resetting an accelerated pace
of a gradualist approach. The recent experience in many countries shows that periods of
impressive macroeconomic performance generate pressures for speedier financial
liberalisation since everyone appears to be a gainer from further liberalisation, but the costs
of instability that may be generated in the process are borne by the country, the government
and the poorer sections. Avoiding crises is ultimately a national responsibility. The approach
to managing the external sector, the choice of instruments and the timing and sequencing of
policies are matters of informed judgment, given the imponderables.
As noted earlier, not only do global developments influence India, but the growing size of
India has also implications for the global economy which would have also to take in to
account the evolving demographic dynamics in countries such as India. Over the next
halfcentury, the population of the world will age faster than during the past half-century as fertility
rates decline and life expectancy rises. In Europe, the demographic profile is already tilted
towards the higher age group and by 2050, this is projected to accelerate. Projections
suggest a turning point between 2010 and 2030 when the European Union, North America
and Japan will experience a substantial decline in savings rates relative to investment which
may be reflected in large current account deficits. Most of the high performers of East Asia
and China are in the second stage of the demographic cycle. Elderly dependency is
expected to double in these countries by 2025. Their working age populations will increase
modestly first and then shrink. These projections suggest that East Asia could increasingly
become an important supplier of global savings up to 2025; however, rapid population ageing
thereafter would reinforce rather than mitigate the inexorable decline of global savings. India
is entering the second stage of demographic cycle and over the next half-century, a
significant increase in both savings rate and share of working age population is expected.
The share of the labour force in population in India is expected to overtake the rest of Asia,
including China, by 2030. Looking ahead, the rest of the world may increasingly rely on
China and India for supplies of both labour and capital and this could significantly influence
the evolution of the global economy. It is evident that China and India will have to give high
priority to generating employment and both are poised for substantial increases in
productivity.
The global economy will have to contend with the implications of these developments on
prices, exchange rates, wages and structures of employment in industrialised countries. Over
the medium term, it is felt that outsourcing will grow rapidly and may also cover high-end
research and development activities. In manufacturing, China has emerged as a leader and
India is catching up rapidly. Though agriculture is heavily subsidised in major industrialised
countries, such subsidisation would be difficult to sustain from a fiscal point of view, since
many of the countries concerned are poised to meet the mounting pension liabilities not to
speak of burgeoning health care costs of maintaining the deteriorating demographics. One
sector where the industrialised economies continue to show considerable strength and
dominance is the financial sector, partly attributable to the confidence factor in financial
markets that favours the industrial