Y V Reddy: Reflections on India's economic development
Address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Council on Foreign
Relations, New York, 12 May 2006.
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Friends,
I am greatly honoured by the invitation from the Council on Foreign Relations to interact with you as
part of the C. Peter McColough Series on International Economics. I intend sharing with you
reflections on India's economic development, not in terms of advocacy or analysis but through a liberal
recourse to anecdotes along with some illustrations. By virtue of my experience and background, the
remarks may combine a worm's view with a bird's eye-view of the Indian economy, in its broader
social context.
In the presentation today, I will -
a) Provide glimpses of the process of some of the institution building in India that enabled the
progress we have made;
b) Analyse the current macro-economic issues as identified by our recent monetary policy
statements;
c) Assess the outlook for the Indian economy by inviting attention to changing balances;
d) Illustrate the importance of balance and harmony with reference to reforms in the external and
financial sectors; and
e) Conclude with a discussion on some factors relevant to the prospects for India in the global
economy.
Institution building
Among the institutions that constitute strong pillars of current optimism on growth prospects over the
long term are: uniquely flexible federalism, democracy with universal adult suffrage, and coexistence
of public and private sector. They deserve some elaboration.
At the time of independence, there were genuine apprehensions as to whether India would hold
together. It is true that at the time of independence, there were over 500 native or princely states,
which had a complex net of relationships with the colonial government in terms of paramountcy. They
had to be integrated into a constitutional framework of a federation. The flexibility of the federal
structure in the constitution assimilated divergent tendencies as they evolved through a process of
political accommodation. For example, in the year 2000, three new States were carved out. We are a
Union of States but a number of States had to be created or re-created on several occasions, while
boundaries were also altered in some cases. India, as per the constitution, started with Hindi as the
official language of the union along with English as an alternate, for a defined period, which again is
being extended. The constitution lists national languages which were 14 in 1950 and are now
expanded to 22. Every currency note that we print has denomination expressed in most of these
national languages. In brief, India has worked hard to build itself into the viable and vibrant political
entity that it is today in a short period while encouraging democracy to take roots.
The constitution of USA or the developments in UK first established democracy and then gradually
conceded to universal adult suffrage over the passage of a couple of centuries. India started with
universal adult suffrage in 1950 and over the decades there has been democratic pressure for rapid
and full inclusion of all sections in the mainstream. Other democracies started with equality and
conceded affirmative actions as a concession to realities. India asserted the goal of equality but
incorporated enabling affirmative actions in the constitution for a specific period - which has been
extended from time to time by common consent. Thus, democracy has taken roots in India essentially
because of, what Stephen Cohen calls, the genius of Indian people for political accommodation and
management.
The expansion of the public sector since independence in this milieu of socio-political transformation
has been a major contributor to today's strengths. Expanded educational opportunities, with nominal
fees, led to high quality in education. People could take advantage of the educational opportunities
since the process was accompanied by expanding job-opportunities in the public sector, based mainly
on performance. In this background, millions were convinced that they needed to work hard at
education to be assured of vertical economic and social mobility. The vast public sector has also
ensured the mobility of the middle class on a nationwide basis and has guaranteed a vibrant
middleclass. This, in turn, produced skilled workers and professionals as well as a large consumer
base and a potential entrepreneurial class. The large public sector has co-existed with a private sector
though the growth of private sector was sometime enabled and often constrained, by the public sector.
The private sector, for its part, learnt to manage, survive and benefit from the public sector while also
being constrained by it. In brief, it is the combination of federalism, democracy and the mixed economy
that produced a pan-Indian vibrant middleclass of professionals and entrepreneurs.
Thus was built an inclusive democracy that virtually celebrates plurality and yet promotes a
selfrespecting nation proud of its unity in diversity. We believe that economic development needs to be
viewed in this broader context. Prime Minister Manmohan Singh summed up the idea in this very
forum - Council on Foreign Relations on September 24, 2004, in the context of Russel C. Leffingwell
Lecture :
"This, (impressive performance) of course is the result of sustained efforts, over the past 50
years to build those institutions that provide the underpinnings of economic development over
the longer term, efforts that began early on as part of the vision of India's first prime
minister, Jawaharlal Nehru. It is also the result of economic reforms which have increased
our competitiveness in recent years."
Select current issues
Though there are several issues relevant to our economy, in the monetary policy statements in
January 2006 as well as April 2006, the Reserve Bank of India flagged three issues as critical for
maintaining the momentum of growth with stability, namely, the physical infrastructure, fiscal deficit,
and agriculture.
First, the poor state of the physical infrastructure, both in terms of quantity and quality, has been rightly
agitating the business class and the policy-makers. There are some reasons to expect a satisfactory
outcome, provided the improvement in regulatory framework is sustained. The current investments are
demand-led and therefore, are likely to have a short-gestation coupled with a rapid payback on
completion. Technological developments and rapid enhancement of domestic construction capabilities
should aid the process of speedy and efficient implementation. Given the healthy fundamentals of the
domestic financial sector and the enhanced interest of foreign investors, funding should not be a
serious problem. When I mentioned my optimistic assessment on these lines in Basel, one of the
comments was "with miserable infrastructure, India is already competitive in many areas. I should
wonder what happens if the infrastructure really improves".
Second, fiscal consolidation is taking place both at the Centre and States and there is greater
consensus now on the broad directions. The recent budget of the central government brings the
consolidation on track, targeting a fiscal deficit of three per cent by 2009 while eliminating revenue
deficit. Recommendations of the Twelfth Finance Commission (Chairman, Dr. C. Rangarajan) have
reinforced the process to enable further fiscal consolidation at the State level. Our studies on State
finances in Reserve Bank of India give grounds for optimism in regard to their fiscal health. From
2003-04, there has been a sharp correction both in the revenue and fiscal deficits; and the process of
correction is primarily due to buoyancy in revenue receipts, States' own tax revenue as well as transfer
and devolution of resources from Centre. It is noteworthy that for all the States together, the revenue
deficit relative to the GDP is estimated to decline to 0.4 per cent in the current year from one per cent
in the previous year and 2.7 per cent in 1990-2000. The corresponding picture for the Gross Fiscal
Deficit relative to the GDP is 3.1 per cent compared to 3.7 per cent in the previous year and 4.7 per
cent in 1990-2000. However, the issues of power subsidies and ensuring quality in the delivery of
services, especially with regards to education and health, do need to be addressed.
Third, and perhaps the most difficult, is agriculture. A majority of the workforce is dependent on
agriculture while the GDP growth due to agriculture is marginally above the rate of growth of the
population, in contrast to a strong growth rate in the non-agriculture sector. This has generated an
understandably widespread feeling of absolute as well as relative deprivation among the farmers and
the agricultural labour. While the scope for better terms in the global trading environment is still
elusive, India has a large enough domestic market to facilitate a more rapid growth in agriculture. Yet,
legislative, institutional and attitudinal changes to supplement enhanced public and private investment
may be needed. The Reserve Bank, for its part, is redoubling its efforts in revitalising the rural
cooperative credit system, in strengthening Regional Rural Banks, in providing incentives to
commercial banks for investments in rural economy and in ensuring an adequate and timely delivery
of credit at an appropriate price. In fact, we are mounting a study of legislation and implementation of
non-institutional money lending, as it is the single largest source of credit for the farmers.
Outlook - changing balances
Progress in India is essentially one of shifting balances. These balances shift almost continuously, and
often imperceptibly, and it is possible to hold that one way of assessing the outlook for the Indian
economy would be to appreciate these changing balances.
First, there is a changing balance in the debates on economic reforms. So far, the discussions have
percolated from the English media to the vernacular (with the divide between the English media and
the vernacular corresponding roughly to a socio-economic/urban-rural divide). It is interesting to note
that while 17 leading English newspapers have a combined circulation of 6.3 million and readership of
17.9 million, 54 leading vernacular newspapers in India have a circulation of 21.4 million and a
readership of 197.2 million. Important economic issues are more and more likely to be articulated and
shaped by the vernacular media and distilled up to the English media, since it is the vernacular that
predominantly represents the rising 200 million middleclass.
Second, there are changes in the vertical balance between Central and provincial or State
governments. The trend towards globalisation results in many of the discretionary powers of the Union
government in the economic area becoming aligned with bilateral or multilateral requirements while
critical areas for role of government in the economy like law and order, education, health, power,
water, etc., remain substantively in the domain of the provinces. That a few years ago, many in the
world would not have heard of State chief ministers while they do so now, points to an increasing
decentralisation of economic reforms.
Third, the horizontal inter-provincial balance is also changing. Now, States are competing for private
investments - the drivers of growth - whether domestic or foreign. A competition among the States for
the Central government assistance on the basis of backwardness or need, has been replaced with
competition for private investments facilitating growth.
Fourth, within governments both at the union and provincial levels, regulatory agencies are expanding
their role to reduce the discretionary or possible pro-political cycle authority of governments.
Fifth, the most dynamic element of reform is the mix between public and private ownership of
enterprises. The rebalancing of public enterprises is not dramatic but the entry and threat of the private
sector and a diversified ownership of public enterprises through partial disinvestment have meant a
change in both the operating environment and internal business culture of these enterprises - which,
until recently, had employed and retained the largest pool of the best and the brightest. It is no wonder
that the equity markets in India have given a big 'thumbs up' to many public enterprises, including
banks.
Sixth, the enormous and growing diversity in the funding and provision of essential services, such as
health and education, is worth exploring. The enrolment in private schools or colleges, often funded
through grants-in-aid, exceeds that in public sector in many States. On the one hand, this is positive -
since the fees are currently affordable, but on the other, it is a cause for concern since it implies that
the public sector is not able to deliver. In the short term, this is a waste of resources and in the long
term has the potential for undermining the greatest strength of India - a credible hope for millions,
particularly the poor and under privileged, that there is a better tomorrow through better education.
The enhancement of the quality of education - primary, secondary and collegiate - in the large public
sector is a most difficult yet crucial challenge. Some efforts are being made in this regard by many,
such as Azim Premji - the Chairman of one of the largest software companies in India - and the Tatas,
one of the largest industrial houses in India. Ensuring access to quality education for the
underprivileged in India is an issue that should be of greatest concern to all thoughtful and concerned
people of the world. Similar concerns can be raised with regard to the vital area of public health. Here,
the private sector is an alternative, though often not an affordable one for most Indians. I am happy to
note the efforts of the Bill and Melinda Gates Foundation as well as the participation of McKinsey's
Rajat Gupta in the Public Health Foundation of India.
Seventh, there is a dramatic though not fully appreciated rebalancing within the private sector in terms
of what may be called the "professionalisation" of industrial houses. A new, highly qualified and
professional generation of leadership has replaced the older order in established industrial houses. At
the same time, there has been an explosion of an entirely new set of industry leaders, particularly, in
newer fields such as software, pharmaceuticals, biotech and financial services. The
professionalisation is also accompanied by the globalisation of the operations of the Indian industrial
houses.
Eighth, sometimes it is argued that large size is absent in the Indian industry, but it is the wide
spectrum of size and diversity that imparts dynamism and generates an entrepreneurial class as well
as employment. In the recently held Davos summit, an Indian industrialist referred to two aspects of
our business environment. He said that Indian business is often faced with chaos and out of chaos
comes creativity. He added that the cost per unit of output may often not be very low in India, but the
cost per unit of innovation is!
Ninth, the relationship between labour and management is being gradually rebalanced. It has certainly
improved since the 1991 reform. The recent data on strikes and number of working days lost bear
testimony to the maturity and wisdom of all concerned. Often, the labour market is cited as a problem
but many globally competitive Indian businesses do not seem to perceive it as an insurmountable one.
Further, the implementation of provisions relating to labour market under the Industrial Disputes Act,
which is broadly in line with international standards, is becoming more pragmatic and less dogmatic in
many progressive States. However, the need for greater labour flexibility with attendant appropriate
legislative changes, keeping in view the socio-economic conditions, is undeniable.
Tenth, there is often a concern about jobless growth, but in reality it is necessary to distinguish
between lack-lustre growth in employment in the organised sector and expansion and intensification of
employment in the unorganised sector. By way of illustration, thirty years ago, eighty per cent of
engineers or doctors moved into the organised sector, while now, sixty to seventy per cent are
selfemployed. This implies a shift in the balance from what may be termed as 'job orientation' to 'work
orientation'. Despite these positive developments, the greatest challenge before the nation is to create
productive work for the millions that are entering the market.
Finally, during the process of reform there is an initial tendency to be pro-business to get quick results
while for lasting impact, policy needs to be pro-market. The processes of decision-making, often
considered painfully slow in India, are gradually emphasising an increasingly pro-market stance.
Reforms in external and financial sectors - balance and harmony
What are the dominant characteristics of reform in the external sector? On the trade account, the
approach was to indicate the direction and to encourage participants to equip themselves better,
notwithstanding the risks of anticipatory actions undermining the policy intent. In this context, a
distinction needs to be made between promoting growth and enhancing efficiency in the context of
economic reforms. Trade reforms in India were designed to enable domestic firms to restructure and
spread the costs of adjustments over time - thus enabling enhanced efficiency through a gradual
process. Growth is promoted on a longer-term basis in view of efficiency gains that were made
possible by the gradualist approach.
On the capital account also, there has been a continuous resetting with a view to the accelerating
gradual pace of liberalisation depending on the domestic and global situation but the direction has not
been compromised. While there is full convertibility on the current account, and also for all authorised
inflows as well as outflows on the capital account, the process of managing the capital account
consists of operating two routes, namely automatic and non-automatic. As far as foreign direct
investment is concerned, consistent rebalancing in the desired direction is done by expanding the
automatic route and by moving most of the prohibited transactions to the non-automatic but approval
route and at a later stage, to an automatic or deregulated regime. There is full convertibility for portfolio
flows through Foreign Institutional Investors as far as equity markets are concerned. A major area of
managing the capital account relates to external debt and the objective in this regard is, in a way, to
ensure that short-term debt obligations conform to what is known as Guidotti-Greenspan prescription
for avoiding crisis in the emerging economies. As regards residents, a distinction is made between
resident individuals, the corporates, and financial intermediaries - and a process of gradual
liberalisation for each category, as appropriate, is the general approach. Currently, there is virtually full
capital account convertibility for Indian corporates while a roadmap for the future in regard to fuller
capital account convertibility is expected from a recently appointed committee on the subject, by
endJuly 2006.
The emphasis on balance and gradual rebalancing, keeping in view the desired direction and the need
to avoid any roll-back, is thus evident in regard to the external sector and is equally significant for
progress in the financial sector -basically following the visionary design of Dr. C. Rangarajan, one of
my predecessors. A few illustrations of gradualism may be in order.
First, the Reserve Bank was, till recently, de facto obliged to provide money to the government
whenever needed, be it through overdrafts or through private placement of government debt with the
Reserve Bank or through participation in the primary issues. These have been eliminated with effect
from April of this year, but the formal process was commenced in 1997, with a memorandum of
understanding with the Government to eliminate automatic monetisation. More recently, private
placement or participation was avoided. After being convinced that the new system works in practice,
it has been possible to discharge the relevant mandate of the Fiscal Responsibility and Budget
Management Act with effect from April 2006.
A second example relates to relaxations in foreign exchange regulations. The Foreign Exchange
Regulations Act, 1973 prohibited most of the forex transactions unless exempted, and so, the initial
process of liberalisation involved enlarging the list of exemptions. This culminated in replacing the
above Act with the Foreign Exchange Management Act in June 2000, where all transactions are
permitted unless prohibited or regulated.
A third example relates to competition and ownership of banks. Competition has been enhanced by
gradually removing administered interest rate structures, permitting entry of new private sector banks,
and expanding the branch network of foreign banks. Unlike in most countries, a branch of a foreign
bank in India can conduct any business that a bank incorporated in India may do. On ownership, while
over 70% of the banking business was in fully public sector-owned banks ten years ago, it is now less
than 10%, since there is a mix of public and private ownership in most of the public sector banks. In
fact, in many large public sector banks, foreign ownership is close to domestic private ownership. The
two largest private sector banks have foreign ownership of about 70%. The shares of most domestic
banks are quoted and traded in local stock exchanges and if stock market is any indication of the
outlook, the prospects for public sector banks are bright.
In this process of reform in the banking sector, the legacy problem of non-performing assets were
managed by the public sector banks themselves - with no banking crisis or ex post fiscal bail out. The
government has actually benefited from the infusion of some capital in the public sector banks which
was done to comply with the Reserve Bank's prudential regulations. By all accounts, the banking
system as a whole has improved in terms of efficiency and resilience gradually, with the mix between
public and private and domestic and foreign banks, changing incrementally to enable non-disruptive
enhancement of competitive efficiency and stability.
Along with continuous rebalancing within each sector, harmony in reforms across sectors is
continuously sought. In a way, the complex tasks of timing and sequencing of reforms in India have
been managed through continuous rebalancing within a broadly harmonised policy-framework, often
incrementally and rarely in a dramatic fashion. For example, the progress in reforms in monetary
management and financial sectors has been impressive, and in the external sector, de facto, very
significant. Progress in the fiscal sector has not been as rapid, influencing the pace of reform in the
financial and external sectors. Similarly, flexibilities in the real economy are necessary if the fruits of
marketisation are to be obtained without the attendant risks. Several rigidities, especially in the
regulatory environment and the agriculture sector, are being gradually removed and reform in other
sectors cannot be out of tune. Finally, clarity in property rights, enforcement, dispute resolution etc., on
an expeditious and reasonably predictable basis is also being pursued on several fronts, so that
further progress can be made - say, in pricing of risks by banks as efficiently as they happen in
developed economies.
Our experience in regard to development and regulation of financial markets differs from that of
developed economies. The latter experienced a co-development of markets, regulations, and practices
within the economies and at a latter stage, through a process of evolution, integrated first domestically,
and finally, globally. In our case, non-existent or underdeveloped domestic market participants had to
change their outlook rapidly. The regulators had to develop the requisite skills, and the self-regulatory
organisations needed to be founded and strengthened. All these had to take place with narrower
degrees of freedom and in a shorter time-span, in view of global developments and financial
integration with its pre-disposed as well as preferred frameworks. The constant plea for the country
context in reforms in the financial sector may be viewed in this analytical framework.
India and global economy
There are several complex factors relating to domestic economy that would influence the manner in
which India will evolve in and integrate with global economy in the long run. While it is beyond the
scope of this address to attempt analysing them, it is proposed to discuss some of these domestic
factors namely, trade offs between efficiency and stability; importance of political stability, process of
empowerment of women, governance issues and demographic transition.
The balancing of efficiency considerations with stability will be critical in India's successful integration
into the global economy. While several observers, especially in the financial sector, hold that India is
risk-averse, there are others who assert that a risk-sensitive approach has paid rich dividends both in
terms of efficiency as well as stability. Two illustrations may suffice. At a macro level, India is investing
around 30% of GDP and recording a GDP growth rate in the range of 7% to 8% - which reflects a high
level of macro-efficiency relative to other high growth performers in Asia. Second, at a micro-level,
there is evidence of increasing global competitiveness - in particular, in the manufacturing industry
despite several handicaps such as the cost per unit of power in India, which is two to three times
higher than that in other Asian countries. Also, savings-investment balance is - and perhaps likely to
be - reasonable at around 2 to 3% of GDP as current account deficit. Going forward, India's
risksensitive approach to management may ensure that it contributes to domestic growth and global
stability.
Issues of political stability are closely related to those of economic stability - and the stability of the
political system in India is noteworthy. The number of coalition partners in the government, number of
prime ministers and indeed, of a series of elections to the Parliament and State assemblies in recent
years may appear to indicate difficult political cycles. Yet the overall progress in economic and,
indeed, social fronts in the recent years, despite the apparently tortuous processes, demonstrates that
economic policy cycles do not necessarily go with political cycles in India. There are grounds for
optimism on the continued optimal balancing between socio-economic change and political system
stability.
No doubt, terrorism is a serious problem but it is a localised problem and the essential fairness of an
open multi-cultural society provides hope against any lasting adverse impact on stability. It is
significant that there have been attacks on the iconic symbols of India - Parliament, temple, mosque
and the Indian Institute of Science. And in all these cases, evidence is that it was driven by the
nonresidents.
It is useful to recognise the importance of empowerment of women. Let me illustrate with some
relevant facts in my home State, Andhra Pradesh. There is a reservation of one-third for women in
medical colleges, but as of now, around half the students are women. Of the 92,000 students admitted
in engineering colleges this year in Andhra Pradesh, over 30,000 were women. Similarly in the political
arena, women are well represented. In the local bodies, there are about 250,000 elected officials
ranging from a member of Gram Panchayat to Mayors of Municipal Corporation and chairpersons of
Zilla Parishads and of these, over 85,000 are women; and the reservation for women has been
operative since 1987. These developments, which are shared in different ways by other States, give a
positive twist to the outlook for empowerment of women for the future.
The exploration on the future of India will not be complete without reference to a book by my
predecessor Dr. Bimal Jalan with the title 'Future of India : Politics, Economics and Governance'. In
particular, he highlights issues relating to enhancing the quality of functioning of the parliament, the
bureaucracy and the judiciary. These are complex issues, but the continuation of the good times in the
economy is perhaps contingent upon the needed reforms in these areas - sooner rather than later.
India is expected to benefit from the demographic dividend in a global context. It is necessary to
recognise that the bulge in the workforce, which is a source of strength, will be concentrated in
Northern provinces of India. If education, skills, health and governance are improved to enable a
globally competitive labour force, there will be a demographic dividend. There is a greater advantage
for India, relative to almost all other countries, in that the demographic transition in India will be
stretched over a longer period due to the sheer diversity in demographic profiles among different
States. By 2016, in three States - Tamilnadu, Kerala and Andhra Pradesh - the proportion of the
elderly as a percentage to the total population will be in excess of 10 per cent. On the other hand,
Uttar Pradesh and Bihar, the two most populous States of India, are likely to have the lowest share at
6.7 per cent and 7.1 per cent respectively. A preliminary observation based on the migration data as
per Census 2001 shows that Uttar Pradesh and Bihar are the two States already experiencing the
highest number of people emigrating to other States in India. Employment appears to be the dominant
factor for migration and this is a positive factor for us. In brief, the demographic profile of India may, in
some ways, be mimicking the global profile.
It is interesting that the extreme diversities of the world in terms of languages, religions, ideologies and
traditions are reflected in India. There is an overwhelming preference in Indian society and polity for
coordination, cooperation and co-option rather than confrontation. In sum, if there is one country that
is closest to a well functioning, multi-cultural global village, it is India.
Indo-US relations
In conclusion, some thoughts on Indo-US relations would be in order. The single largest segment of
the best and the brightest of India residing outside the country is in the USA, and their assimilation is
both smooth and productive. An important source of overseas students in the USA is from India, and
the Indian-Americans carry the goodwill for the USA wherever they happen to be. These are among
leaders and opinion makers not only in the USA and in India, but also globally. The single largest
group of non-resident Indian professionals returning to India to participate in the growth story of India
are from the USA. Finally, as Ambassador Blackwell said in this very forum, Council on Foreign
Relations on February 23, 2006, in a Journalist Roundtable 'Indians like the United States. According
to the Pew Poll, [....] "India regards the United States more positively than any other country in the
world, it turns out'.
Thank you, ladies and gentlemen.