2002/03; (ii) a petroleum subsidy of 0.4 percent of GDP; and (iii) a power subsidy of 1.5 percent of GDP of which about 0.5 percent is explicitly included in state government budgets and the balance is an implicit subsidy.

Foodgrain and input subsidies have distorted farmer cropping and investment decisions and thereby contributed to natural resource degradation (soil nutrient imbalances, water logging, salinity, etc.). At the same time, public investments in agriculture over the last decade have declined in large part because of the need to finance subsidies in the foodgrain, fertilizer, irrigation, and power sectors. Therefore, a shift in central expenditures from food (subject to the maintenance of a minimum social safety net) and fertilizer subsidies towards productivityenhancing investments, including irrigation, rural infrastructure, and research and extension, would give the agricultural sector and off-farm employment a much-needed boost.<sup>48</sup> The petroleum subsidy is to be phased out over the medium term. The power subsidy is much more difficult politically, even though it is regressive and the poor benefit little from subsidized electricity.<sup>49</sup> Tariffs covered only 68% of the cost of supply in 2001/02. At the same time, there is high dispersion in tariffs, with commercial and industrial users cross-subsidizing agricultural and domestic consumers and being charged rates far in excess of the cost of supply. As a result of this and the poor quality of supply, many manufacturing companies install their own generators.

The financial and social case for power sector reform is clear, as are the essential elements. Average tariffs need to be raised to reflect cost of supply; universal metering of consumption is required, especially for agricultural and domestic consumers; payments discipline needs to be enforced; and a targeted subsidy scheme needs to be introduced for poor households and farmers so that the cross-subsidy burden on industrial and commercial users can be eliminated. GoI has recently initiated a few potentially decisive steps to give states stronger reform incentives.<sup>50</sup> For these to work, privatization of distribution, stronger action on tariffs, governance improvement and financial restructuring are needed.

On guarantees, there are two issues: what to do about the existing stock; and how to minimize or stop the new flow altogether. On the first, one idea is to create a guarantee redemption fund,<sup>51</sup> though the question is how this will be funded given fiscal constraints. Besides, it will work only in conjunction with a correction of the fundamental problems in power and irrigation – especially tariff setting – which is also needed to stop the flow of new guarantees which would otherwise be needed for fresh borrowings to finance continued losses.

An important spin-off from fiscal reform will be to enhance the role of the financial sector in efficient resource allocation<sup>52</sup> and thereby reap the benefits associated with a more liberalized financial system. Another challenge is to minimize financial sector risks and thereby the build up of contingent fiscal liabilities. In this connection, the new Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Bill (2002), which allows banks to take over collateral more easily, could push debtors to pay up. Similarly, establishment of Credit Information Bureaus should help in sharing information on credit risk, which would lower transactions costs while also helping to control NPLs. It would particularly

> 48 Deininger and Deininger (2001) and the forthcoming paper on ‘Targeted Public Distribution System: Is it Reaching the Poor?”

> 49 World Bank (2001b) and (2002b).

> 50 Parliament passed a new Electricity Act in 2003 and the Ministry of Finance launched the Accelerated Power Development and Reform Program.  For more details, see World Bank (2003a). 51 RBI (2003e)

> 52 See for example the analysis in Bossone, Mahajan and Zahir (2003) which explores through a choice theoretic model how changes in financial infrastructure affect the investors’ resource allocation decisions and also tests empirically the hypothesis with cross-country regressions.

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