**Policy Research|**

<!-- Start of picture text --> Industry and Finance Operations<br>WPS 873<br><!-- End of picture text --> 'T'his papera product of the Industry and Finance Operations Division, Country Department IV (India), - Asia Regional Office is derived from Policy Research Working Paper 433 (August 1990), which was part of a larger effort in the department to undertake a comprehensive review of India's trade regime and policies and to make recommendations for liberalization of its trade policies. Copies of the paper are available free from the World Bank, 1818 H Strcet NW, Washington, DC 20433. Please contact Francois Ettori, room H4-085, extension 32340 (March 1992, 24 pages).

A striking feature of India's protective structure has been high tariffs and protection on capital goods, which limit industrial competitiveness and export potential, and distort industrial incentives as indicated in "effective protection rates" (EPRs).

The distortions introduced by high capital and investment costs resulting from high levels of protection were corrected in India's analysis by introducing the notion of "corrected effective protection rates" (CEPRs). In theory, EPRs computed on the basis of value added _net_ of depreciation could be made immune from capital cost distortions, provided that depreciation allowances are computed on economically meaningful grounds and that EPRs based on net value added ar-e available. But in India as in many developing countries, available EPRs are based on gross value added. The need to account for the substantial capital cost distortions led to the use of a substitute tool, the CEPR.

The paper provides a brief refresher, and geometrical interpretations, on the definition of F.PR and its limited interpretation as a measure of the scope for inefficiency or extra profit resulting from protection. It introduces the notions and fornulae for the CEPR and the "net effective protection rate" (NEPR). The relevance of these notions and their magnitude are tested on a sample of 60 industrial projects in India.

The paper confirms the finding in a previous Bank review of India's industrial sector that effective protective rates averaged about 40 percent in the sector, with large variations between the industrial subsectors and within each subsector.

Using NEPRs, the paper shows that on _average_ the amount of effective protection available from India's protective structure is just enough to compensate for the high cost of investment that results from heavy protection of capital goods. Most projects have, in effect, negative NEPRs, so they are at a disadvantage compared to foreign competitors.

Finally, the paper argues that reforming India's trade policies and reducing its protection - rates would be mcaniingless even damaging - if India does not first reduce protection on capital goods. When warranted, the nominal protection rate for capital goods should be slashed to the lowest possible level above the shadow premium for foreign exchange.

ThePolicy Research Working PaperSerics disseminates the findingsof work under way in thc Bank. Anobjectiveof the series is to ,et these findings out quickly, even if prcsentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

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