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# Services Reform and Manufacturing Performance Evidence from India

_Jens Matthias Arnold Beata Javorcik Molly Lipscomb Aaditya Mattoo_ The World Bank Development Research Group Trade and Integration Team January 2012
Policy Research Working Paper 5948

# **Abstract**

The growth of India’s manufacturing sector since 1991 has been attributed mostly to trade liberalization and more permissive industrial licensing. This paper demonstrates the significant impact of a neglected factor: India’s policy reforms in services. The authors examine the link between those reforms and the productivity of manufacturing firms using panel data for about 4,000 Indian firms from1993 to 2005. They find that banking, telecommunications, insurance and transport reforms all had significant, positive effects on the productivity of manufacturing firms. Services reforms benefited both foreign and locally-owned manufacturing firms, but the effects on foreign firms tended to be stronger. A onestandard-deviation increase in the aggregate index of services liberalization resulted in a productivity increase of 11.7 percent for domestic firms and 13.2 percent for foreign enterprises.

This paper is a product of the Trade and Integration Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at iborchert@worldbank.org, bgootiiz@worldbank.org, agrover1@worlbank.org, and amattoo@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Services Reform and Manufacturing Performance: Evidence from India**

Jens Matthias Arnold* Beata Javorcik** Molly Lipscomb*** Aaditya Mattoo**** Keywords: services reform, manufacturing productivity, foreign direct investment JEL Codes: L8, F2, D24

## **_______________________________________________**

* OECD Economics Department, 2 rue André Pascal, 75116 Paris, France. Email: jens.arnold@oecd.org. ** Department of Economics, University of Oxford and CEPR, Manor Road Building, Manor Road, Oxford OX1 3UQ, United Kingdom. Email: beata.javorcik@economics.ox.ac.uk. *** Department of Economics, University of Notre Dame, Notre Dame, IN 46556, USA. Email: molly.lipscomb.5@nd.edu **** World Bank, 1818 H Street, NW; MSN MC3-303; Washington, DC 20433, USA. Email: amattoo@worldbank.org. The authors are grateful to Ann Harrison, Giovanna Prennushi, Arvind Subramanian and participants of the 2011 Annual Bank Conference on Development Economics, CEPR GIST workshop, DEFI conference and seminars at DFID and the University of Nottingham for useful comments. This paper is part of a World Bank research project on trade in services supported in part by the governments of Norway, Sweden, and the United Kingdom through the Multidonor Trust Fund for Trade and Development, and by the UK Department for International Development (DFID).  The views expressed in the paper are those of the authors and should not be attributed to the OECD, to the World Bank, its Executive Directors or the countries they represent.
# I. **Introduction**

A vital element of India‟s rapid economic growth since the early 1990s has been the improved performance of its manufacturing sector. Output in manufacturing grew by 5.7 percent per year in the period 1993-2005 (Reserve Bank of India, 2008). Previous explanations for the revival of manufacturing emphasize trade liberalization, more permissive industrial licensing policies, and the limited labor market reforms undertaken since 1991 (see review below). In focusing primarily on proximate policies, however, previous analyses have ignored what we demonstrate is a critical factor, policy reforms in services sectors.

The neglect of services is surprising, first of all, because service inputs, notably finance, transport and telecommunications, are an important component of inputs to manufacturing, so the potential for downstream effects is large.<sup>1</sup> Moreover, reforms in the 1990s, allowing greater foreign and domestic competition with greatly improved regulation, have visibly transformed these services sectors.<sup>2</sup> Indian firms are no longer at the mercy of inefficient public monopolies, but can now source from a wide range of domestic and foreign private sector providers operating in an increasingly competitive environment. Available evidence suggests that firms today have access to better, newer and more diverse business services.

In this paper, we address three questions: Has services reform led to an increase in manufacturing productivity? Have reforms in some services had a bigger impact than in others? Have some manufacturers (e.g. foreign firms based in India) benefitted more than others? These questions matter profoundly for policy; not only is services reform in India incomplete, but across the world some of the

> 1 These inputs affect _inter alia_ a firm‟s ability to invest in new business opportunities and better production technology, to exploit economies of scale by concentrating production in fewer locations, to efficiently manage inventories, and to make coordinated decisions with their suppliers and consumers. Ethier (1982) provides theoretical support for this argument, showing that access to a greater variety of inputs results in higher productivity among downstream industries. Markusen (1989) argues that many producer services are both differentiated and knowledge-intensive. Knowledge intensity in turn suggests strong scale economies in that knowledge must be acquired at an initial learning cost, after which the knowledge-based services can be provided at a very low marginal cost. His theoretical results suggest the possibility of significant gains from liberalized trade in producer services. The importance of intermediate inputs for productivity growth has also been emphasized in theoretical contributions of Grossman and Helpman (1991). A recent theoretical contribution by Jones (2010) draws attention to how linkages between firms through intermediate inputs result in a multiplier similar to the one associated with capital in a neoclassical growth model. This multiplier is large because of a high share of intermediates in output and thus helps account for differences in incomes across countries.

> 2 India implemented significant liberalization in both goods and services between 1991 and 2005.  Major liberalization reforms began in 1991 as part of an IMF structural adjustment package, designed to combat balance of payments imbalances, and continued with the government‟s eighth four year plan from 1992-1996. As we discuss below, the pace of reform in services was gradual and sought to balance a variety of economic and political considerations.

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most intransigent policy restrictions today are in services.<sup>3</sup> Convincing evidence that these restrictions penalize the politically cherished manufacturing sector could provide an impetus to reform.

Exploring whether there is a systematic link between liberalization in services sectors and the performance of firms in downstream manufacturing industries requires three types of information: a measure of policy reform in services, a performance measure for manufacturing firms and information on the linkages between different sectors of the economy.

In preparation for this study, a large amount of information on the state and the history of services reform was gathered by local consultants employed by the World Bank in India. The information was then condensed into a composite time-varying policy index for each sector modeled after a similar index compiled by the European Bank for Reconstruction and Development for countries in Central and Eastern Europe and reported in their flagship publication _Transition Report 2004_ . The index can take on values ranging from 0 to 5 and is available for four sectors: banking, telecoms, transport and insurance for the time period 1991-2004, the period over which most of the significant reforms took place. Constructing the index is one of the contributions of this study, as it can be used in other research on the impact of Indian policy reforms.

The performance of manufacturing firms is measured on the basis of total factor productivity estimates obtained from sector-specific production functions. To take into account the possible simultaneity bias between unobserved productivity shocks and input choices, we follow the procedure outlined by Ackerberg, Caves and Frazer (2006) which builds on the earlier work by Olley and Pakes (1996) and Levinsohn and Petrin (2003). Unlike the latter method, the approach we follow allows for more plausible assumptions about the timing of the firm‟s decision regarding input choices and optimization errors.

To examine the link between the performance of services users and services sector reforms, our analysis relates the productivity of manufacturing firms to the state of liberalization in services sectors weighted by the respective manufacturing sector‟s reliance on inputs from each services sector. The reliance of manufacturing sectors on services inputs is assessed based on the national input-output matrix. Our

> 3 Even in industrial countries, the supposed strategic importance of some services has led to the persistence of restrictions. For example, witness the barriers to foreign participation in air and maritime transport as well as certain types of communication services in the United States, and the difficulty in completing the single market for services in the European Union.

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identifying assumption is that the effect of reforms in specific services sectors should be more pronounced in manufacturing sectors relying more heavily on those services inputs. The specification also controls for the level of import tariffs on output and inputs as well as for firm and year fixed effects.

The analysis is based on firm-level data from the Capitaline database, a commercially available database including balance sheets, profit and loss statements, and ownership information on large private and public firms operating in India. Firms included in the database account for 62 percent of India‟s total manufacturing output during the period covered by the analysis. Our data set forms an unbalanced panel covering 3,771 firms or 22,558 firm-year observations during the 1993-2005 period.

Our results suggest that policy reforms in services sectors had a significant impact on firms in the manufacturing sector. The aggregate effect of services liberalization was an increase in productivity of 11.7 percent for domestic firms and 13.2 percent for foreign firms for a one-standard-deviation increase in the liberalization index. When the individual services sectors are examined in the same specification, a one-standard-deviation change in the banking sector index corresponds to a 6.5 percent change in productivity for both domestic and foreign firms. A one-standard-deviation change in the telecommunications liberalization index corresponds to a 7.2 percent increase in productivity for domestic firms and a 9.8 percent increase in productivity for foreign firms. A similar change in the transport index leads to a 19 percent improvement in productivity of all firms. Only foreign firms appear to benefit from the insurance reform enjoying a productivity boost of 3.3 percent.

Our results are confirmed by an instrumental variables approach in which we instrument for reform in India using measures of services reform in two countries that can be viewed as India‟s competitors, namely China and Indonesia. The results are also robust to focusing on structural breaks in services reform instead of using the reform index. Finally, the results remain unchanged if we control for delicensing and lifting of restrictions on FDI inflows in a given manufacturing sector.

This paper proceeds as follows. Section II describes the related literature. Section III describes services liberalization in India between 1990 and 2005 and presents some evidence on its impact. Section IV describes the data and the construction of the liberalization index and reviews our estimation procedures. Section V interprets the results, and section VI concludes.

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# II. **Related Literature**

A review of the relevant literature reveals that: India‟s manufacturing revival has been attributed to almost everything except its services reforms; even research on other countries tends to attribute changes in manufacturing performance to goods trade liberalization and foreign direct investment; and, in the few instances where the role of services reform is considered, the focus has been on specific services like banking or infrastructural services alone.

India‟s liberalization in the 1990s has made it a rich environment for research on the effects of policy reform on manufacturing performance. Considering the 1991 reforms as a single event, Krishna and Mitra (1998) find both price and productivity effects at the firm level. Khandelwal and Topalova (2011) examine reductions in trade protection in individual industries and find that procompetitive forces, resulting from lower tariffs on final goods, as well as access to better inputs, due to lower input tariffs, increased firm-level productivity, with the latter having a larger impact. Sivadasan (2009) considers the liberalization of both the trade and FDI regime in manufacturing and concludes that both increased firmlevel productivity. In a descriptive analysis, Goldberg et al. (2009) show that trade reform spurred imports of previously unavailable products. New imported inputs often originated from more advanced countries and new imported varieties exhibited higher unit values relative to existing imports. Goldberg et al. (20011a) find that lower input tariffs accounted on average for 31 percent of the new products introduced by Indian firms, which suggests that an important consequence of the input tariff liberalization was to relax technological constraints through firms‟ access to new imported inputs that were unavailable prior to the liberalization.

Other key contributions have looked beyond policy in manufacturing _per se_ , but focused primarily on institutional factors affecting the distribution of benefits from reforms and liberalization across industries and states. Besley and Burgess (2004) exploit variation in labor regulations across Indian states and find that labor market reforms were a significant determinant of manufacturing output per capita. Aghion, Burgess, Redding and Zilibotti (2008) show that the effects of liberalizing the system of central controls regulating entry and production activity were stronger in areas where organized labor was relatively weak, 5
arguing that firms were better able to adapt to the new regime in regions where regulations were more pro-industry. Harrison et al. (2011) find that market-share reallocations played an important role in aggregate productivity gains immediately following the start of India‟s trade reforms in 1991. However, aggregate productivity gains during the overall 20-year period from 1985 to 2004 were driven largely by improvements in average productivity, which can be attributed to India‟s trade liberalization and FDI reforms. Goldberg et al. (2011b) investigate the impact of liberalization on Indian firms‟ product choice and find little evidence of “creative destruction” in the 1990s, i.e. Indian firms infrequently discontinued product lines even during a period of trade and structural reform. They argue that remnants of industrial licensing and rigid labor market regulation in the Indian economy prevented firms from adjusting fully to reforms.

The emphasis on attributing changes in manufacturing performance to changes in trade, investment and labor market policies in goods characterizes much of the existing empirical work on liberalization in developing countries. For instance, Pavcnik (2002) uses plant level data from Chile to find that trade liberalization forces exit of the least productive firms while increasing productivity of the remaining firms in the import competing sectors. Amiti and Konings (2007) delve deeper into the channels through which liberalization affects productivity by separately identifying the impact on Indonesian manufacturing of input and output tariff reductions, and find that the positive effect from increased availability of inputs to production is twice as strong as the effect from import competition. Halpern et al. (2009) estimate a structural model of importers using product-level data for all Hungarian manufacturing firms and reach a similar conclusion.

Empirical research on liberalization of foreign direct investment has produced mixed results. Aitken and Harrison (1999) find what they term „the market stealing effect‟ of foreign direct investment which swamps the positive effect of technology transfer on firm productivity in Venezuela. Javorcik (2004) explicitly distinguishes between intra- and inter-industry effects of foreign direct investment using firm level data from Lithuania and finds that foreign direct investment has a positive productivity effect on supplier industries but no significant effect on local competitors in the same industry. Javorcik and Li (2008) show that entry of foreign retail chains boosts the productivity of the supplying industries in Romania.

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Downstream spillovers arising from policy reform and foreign participation in the services sectors are qualitatively different from those arising from foreign direct investment in manufacturing industries. Disruption in the provision of services can result in large delays in production and product delivery, high information costs and an inability to invest in potentially profitable new activities. There has not, however, been much empirical analysis of the downstream effects of services reform, and the few existing studies have focused on specific services sectors, usually banking.<sup>4</sup> Rajan and Zingales (1998) show that financial development increases growth. They weight industries by dependence on outside financing (as estimated from US data) and find that firms which are more dependent on external financing gain more from financial development than other firms. Bertrand, Scholar and Thesmar (2004) demonstrate that banking deregulation in France in 1985 led to improved productivity in manufacturing firms. Entry and exit rates increased following liberalization, suggesting that less productive firms had been protected by the easy access to credit allocated to large firms by the previously nationalized banking sector. Productivity effects were particularly strong in banking-dependent sectors. Aghion and Schankerman (1999) identify channels through which infrastructure and institutions affect entry and exit. They generate a Dixit-Stiglitz model to demonstrate that infrastructure investment increases the probability of entry by low cost firms and discourages entry by high cost firms. Thus, infrastructure development is likely to improve economic performance if it reduces transactions costs thereby increasing competition and fostering Schumpeterian “creative destruction.” The present paper is most closely related to Arnold, Javorcik and Mattoo (2011) which uses firm-level data to show that increased foreign participation in services provision led to improvement in manufacturing productivity in the Czech Republic in the period 1998-2003. The current paper studies the more complex and dynamic Indian context with new data on and measures of services reform. Furthermore, while the previous paper considered the services sector as a whole, in the present paper, by separating the liberalization measures into measures for banking, telecommunications, transport and insurance services, we are able to identify the impact of key reforms in individual sectors. Finally, in contrast to the previous paper, we distinguish between the implications of services liberalization for domestic and foreign manufacturers.

> 4 There is some work on the economy-wide effects of services reform. Mattoo, Rathindran and Subramanian (2006) show that services liberalization leads to higher levels of economic growth.  Eschenbach and Hoekman (2006) find similar evidence for Eastern Europe.

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# III. **Services Reform in India**

After decades of state dominance, India‟s economic landscape was transformed with the liberalization of manufacturing in the late 1980s and early 1990s, and the liberalization of services during the 1990s. This section describes the key reforms in individual services sectors, their determinants and their consequences. We first provide some evidence that the pattern and pace of services reform reflected sector-specific political forces that were to an extent exogenous to the developments in the downstream manufacturing sector. We then show that the reforms had an impact on the performance of the services sectors.

# **_The Genesis and Pattern of Reform in Services Sectors_**

In the 1980s, the services sectors in India were dominated by state enterprises, there were restrictions on entry by private domestic and foreign providers, and prices of services were largely fixed by the government (World Bank, 2004). The 1990s saw significant liberalization, with greater freedom of establishment to domestic and, in some cases, foreign providers, greater operational autonomy for providers, and greater reliance on market-based allocation mechanisms.

The pace of policy reform has, however, varied across sectors and been determined primarily by political considerations (Hoekman, Mattoo and Sapir, 2007). Sectors in which privatization and competition would mean restructuring and large scale lay-offs were slower to benefit from the reforms than those in which incumbents could remain profitable and employment would not decline even as foreign and local private competitors entered the market. Reforms were also slower to materialize where it was feared that they could cause a reduction in access to services for poor or rural communities. Most political economy explanations for the pace and pattern of reforms point to considerations in the services sectors themselves rather than in downstream industries.<sup>5</sup>

> 5 Chari and Gupta (2008) provide evidence that the de-licensing reforms in India in 1991 categorized certain more concentrated and less competitive industries as strategic and shielded them from foreign competition by maintaining barriers to foreign direct investment. They find that profitable state-owned enterprises were likely to be protected, particularly in capital-intensive industries. Lobbying power by state banks and other services companies in India is likely to have been a factor in delaying

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Services sectors in India can today be separated into three broad categories: significantly liberalized, moderately liberalized and closed. The _telecommunications sector_ was operated solely by the central government prior to 1992, when the government began to issue select operating licenses to private providers. In 1994, cellular service began and the government announced the National Telecom Policy which improved the environment for private investment. In 2002, the government fully opened the long distance sector of the telecom industry to private competition and eliminated all restrictions on the number of service providers, except in areas where limits are dictated by the availability of spectrum. Foreign ownership limitations were also significantly relaxed and now range from 74 percent to 100 percent across different segments.

To those accustomed to the glacial pace of reform in India, the telecommunications experience seems highly unusual. Discussions with policy-makers suggest that technology trumped all other considerations in this sector and India sought to exploit new technological possibilities by rapidly introducing competition.<sup>6</sup> Public sector incumbents reincarnated as more or less successful participants with a stake in a competitive and rapidly growing market. The number of telephone subscribers has increased rapidly, with most of the increases taking place in private telecommunications services providers (OECD, 2011). The expansion in scale dwarfed any adverse effects of diminished labor intensity–employment grew by as much as a third in the six years following the first significant liberalization in 1994. It also became evident that better access to services could be achieved than what had been possible with public monopoly, attenuating concerns regarding distributional equity and weakness of regulatory capacity.

In the moderately liberalized sectors, Indian firms are disadvantaged by the legacies of past policies and are ill-equipped to compete. The best example is the banking sector where nationalization in 1969 of the largest private sector banks led to a sector dominated by public sector banks committed to directing credit to areas identified by the government as priorities.<sup>7</sup> Directed lending and interest rate regulations prescribed the credit portfolios which banks were required to hold, putting into question the long term

> liberalization of the services sectors into the mid-1990s and in excluding them from the general goods liberalization during the rapid trade reforms which took place in 1991.

> 6 The authors discussed the reform experience with B.K. Zutshi, the first Chairman of the Telecom Regulatory Authority of India (TRAI), and H.V. Singh, the Secretary and Director of Economy Policy at the TRAI in December 2006. 7 The Bank Company Acquisition Act of 1969, quoted in Burgess and Pande (2003), explicitly recognizes the goal of expanding credit to priority sectors through government expansion of the banking system.

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solvency of many banks (Reddy, 2005). Banks were also required to hold large percentages of their portfolios in government securities bought at concessional interest rates. In 1977, the government began requiring any bank that wanted to open a branch in an area which already had a bank branch to open four branches in (rural) areas with no financial services (Burgess and Pande, 2005). The effect was to generate excessive staffing levels, unprofitable rural branches and large levels of non-performing loans. The close relationship existing between the banks, the government and central bank created the potential for moral hazard as banks expected government intervention in the event of a failure (Reddy, 2002).

Liberalization of the _banking sector_ was handled by the Reserve Bank of India with a focus on maintaining the viability of existing banks while increasing competition and efficiency in the sector (Reddy, 2005). In 1994, liberalization began with increased approval of private sector banks. In 2001, the government began deregulation of the interest rate, and in 2002, foreign participation in the banking sector was allowed up to 49 percent in private banks. There was also an increase in the approval rate for the entry of new private banks. At the same time, India has made banking sector liberalization conditional on improving the competitiveness of public sector banks through measures such as mergers, voluntary worker retirement schemes, and the creation of asset management companies to deal with non-performing assets. A 2004 rule allowed foreign banks to acquire up to a 74 percent stake in branches listed by the Reserve Bank of India as having weak portfolios; foreign institutions are allowed only a 20 percent stake in branches which are performing well. Foreign banks may now operate through licensed branches and as fully owned subsidiaries, but a few key restrictions remain in the banking sector. There is a cap on the number of licenses for branches at 20 per year for both new and existing banks, and the share of foreign bank assets in total banking assets may not exceed 15 percent. Despite these limitations in the pace of reforms, banking concentration has decreased visibly and the market share of new banks has increased to around 25 percent (OECD, 2011).

The _insurance sector_ has been liberalized more slowly than the other sectors. Prior to liberalization, the insurance sector was controlled by the Ministry of Finance through publicly owned companies. In 1999, the Insurance Regulatory Development Authority bill was passed which allowed private sector companies to enter the insurance market. Foreign equity participation in the insurance sector is restricted to 26 percent and foreign firms are allowed entry only through partnerships or joint ventures. The funds of policyholders must be retained within the country and there is compulsory exposure to the rural and social 10
sector, including crop insurance. Entry into the insurance market by private sector providers finally began in 2002 when twelve private sector insurers entered the market.

All subsectors of _transport services_ were operated primarily by public sector companies prior to liberalization. Air transport was run by two publicly owned carriers, states controlled the ports for maritime industries, and a large segment of the shipping sector was heavily regulated and dominated by publicly owned companies. In 1997, foreign direct investment up to 40 percent was allowed in airlines, 74 percent foreign direct investment was allowed in port construction, and private sector companies were allowed to contract for infrastructure maintenance and construction. In air transport, for example, the remarkable increases in passenger traffic can be attributed almost entirely to private entrants (OECD, 2011). Yet transportation sectors remain subject to state level regulations which vary significantly across states, with trucking particularly susceptible to local political pressures.

_Professional services_ including accounting, legal, and other services sectors such as _retail distribution, postal_ and _rail transport_ services are formally closed to foreign participation.<sup>8</sup> FDI is not allowed in the accounting and legal sectors. Within distribution services, FDI is not allowed in the retail segment (with some narrow exceptions, such as single-brand retail) but there are no limits in other areas, except the requirement of approval for commission agents, franchising services and wholesale trade. The closed sectors are characterized by domestic firms that are sub-optimal in size and handicapped by an inhibiting and weak regulatory environment. Many Indian services in closed sectors are highly fragmented by international standards.<sup>9</sup> Here adjustment and employment concerns are the dominant factors impeding liberalization.

A more detailed survey of the liberalization reforms is provided in on-line Appendix A (attached at the end of the paper).

> 8 As an exception to this general rule, single-brand retailers are allowed.

> 9 For example, there are 100,000 chartered accountants in India and 43,000 audit firms, with an average of two chartered accountants per firm as compared to an average of between 350 and 1500 chartered accountants in the typical affiliates of the “big four” accounting firms. In retail distribution, the penetration of supermarkets in India is only 2 percent compared to 55 percent in Malaysia and 36 percent in Brazil (World Bank, 2004).

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# **_The Impact of Reform_**

The elimination of barriers to entry in services provoked a dramatic response from foreign and domestic providers (Gordon and Gupta, 2004). FDI inflows into services following liberalization by far exceeded those into other sectors. Ten percent of FDI inflows during 1990-2005 went into the transport sector, 9.6 percent of the inflows were into the telecommunications sector, and 9.6 percent of the inflows were into the financial and other services sector (Ministry of Commerce and Industry, 2008). At the same time, the services sector grew by an average of 11 percent per year, with the more liberalized sectors generally growing at relatively faster rates (Chart 1, and Eichengreen and Gupta, 2010). The share of services in overall value added rose from 39 percent in 1993 to 50 percent in 2004 (National Accounts Statistics, 2005, constant 1993 Rs).

Growth has been particularly strong in the services sectors on which we focus in this paper: communication services displayed average annual growth rates of 13.6 percent in the 1990s, while banking grew by 12.7 percent on average, transport grew at an average rate of 6.9 percent and insurance grew at a rate of 6.7 percent (Gordon and Gupta, 2004). Output per worker in the services sectors in India has increased by over 7.5 percent per year during the 1990s, clearly outpacing the agricultural or industrial sectors (Bosworth and Collins, 2008, p.56). Other evidence suggests that strong total factor productivity growth was at the root of this remarkable performance, not capital deepening or higher markups (Bosworth, Collins, and Virmani, 2006; Gordon and Gupta, 2004). Indeed, services prices decreased relative to manufacturing prices, as indicated by a slower pace of growth in the services deflator than the overall GDP deflator.

The reforms produced striking improvements in sectoral performance. In 1990, the average turn-around time for a container at major ports in India was 8 days, and at major Mumbai ports the average was 11. This meant that manufacturing companies exporting their products or importing inputs had to factor in more than a week of transit time for their goods, which increased the cash outlays necessary for exporting and importing. By 2005, the average turn-around time at major ports in India had decreased to 3.5 days, with 4.5 days as the average time at Mumbai ports (see Charts 2 and 3). This reduction in transit time is likely to have improved the ability of Indian firms to compete in highly variable markets such as textiles and electronics in which the ability to respond quickly to changes in demand is crucial.

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Banerjee and Duflo (2004) find that prior to liberalization even at the most efficient public sector banks, bank loan approvals in 64 percent of cases were mechanically made for the same loan amount as prior loans. The rationing of credit by the public sector reduced the ability of companies to respond to new business opportunities and finance improvements in products or production processes. Because liberalization allowed banks to set interest rates at their risk adjusted cost of capital and choose diversified loan portfolios, by 2005 the level of investment by banks increased to 4.75 times the size of investment in 1994. The share of investment by foreign and private banks also increased during the period from 11 percent in 1994 to 24 percent in 2005. Despite the slow pace of reforms, credit provision and investment have increased across the sector, led by foreign and locally-owned private banks (Reserve Bank of India, 2008).<sup>10</sup> Before the beginning of the reforms in telecommunications, the sector was controlled by MTNL, a publicly owned company which provided local telephone service, and VSNL, a publicly owned company which provided long distance service. Both companies were plagued by faults, which averaged 19 faults per 100 stations per month in 1991. In addition, service was poorly distributed and access to new lines was difficult.<sup>11</sup> Businesses were severely handicapped in their ability to communicate with their customers and suppliers and to coordinate activity across plants. Liberalization has interacted powerfully with technological change to transform the telecommunications market. By 2005, the number of faults had declined to 7.5 percent and the waiting lists for telephone services had virtually disappeared in urban areas (Charts 4 and 5). Even rural customers, projected by critics of the liberalization reforms to lose from the privatization, saw increases in access to phone lines. Access to internet services, provided initially only by MTNL, increased quickly as private providers were allowed to enter the market (Chart 6).

In the 1980s, air transport providers and several of the largest shipping companies were publicly-owned companies. After liberalization, increasing competition from foreign companies put pressure on Indian carriers to improve their performance. They responded positively, and operating efficiency increased. In fact, operating revenue per employee in Indian airlines increased over 5 times over the period 1990-2004 from 0.5 million per employee to 2.5 million per employee. The increased efficiency led to continued

> 10 More recently, during the financial crisis, credit provision by foreign banks shrank.

> 11 The communications minister in the 1980s, C.M. Stephens, declared in parliament that telephones were a luxury, not a right, and that anyone unsatisfied with their service was welcome to return their phone as there was an eight year waiting list of people seeking telephone service (Panagariya, 2008 p.372).

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growth of Indian carriers in the period 1990-2005, of nearly 15 percent yearly in passenger traffic and 11 percent yearly in cargo traffic (Directorate General of Civil Aviation, 2006).<sup>12</sup> Until 2002, private sector competition in the insurance market was proscribed, severely limiting the range of insurance services on offer. Market penetration of insurance quickly increased following the entry of private and foreign insurers. After decades of public monopoly, premiums were equal to only 1.9 percent of GDP in 1999-2000, but they jumped to 2.86 percent of GDP by 2002-2003 (Insurance Regulatory and Development Authority, 2004). Government projections at the time of liberalization suggested that market participation by foreign firms in 2005 would reach only 5 percent of the market, but by November 2005, private firms with foreign shareholding had acquired a 34 percent market share. Over the same period, there was limited contraction by Indian public sector incumbents (Department of Public Enterprises, 2003).<sup>13</sup> In sum, liberalization led to a metamorphosis of services in India from a narrow range of products of substandard quality and poor distribution to the current environment in which service providers are highly competitive and offer their consumers, including manufacturing firms, a wide range of new and high quality services products.

# **IV. Empirical Strategy**

In this paper, we investigate whether there is a systematic link between liberalization in services sectors and the performance of firms in downstream manufacturing industries. This exercise requires three pieces of information: a measure of policy reform in services, a performance measure for manufacturing firms and information on the linkages between different sectors of the economy.

> 12 Recently, certain private providers, such as Kingfisher Airlines, have experienced financial difficulties 13 National Insurance Company Limited, Calcutta,  New India Assurance Company Limited, Mumbai, and United India Insurance Company Limited Chennai each cut their staffs by 10 percent, while Oriental Insurance Company Limited, New Delhi cut its staff by 14 percent (India Knowledge @ Wharton,  2006).

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# **_Measuring Services Reform_**

In order to make the detailed information on services sector reforms in India, which was gathered for this study, amenable to quantitative analysis, we condense the information into a composite policy index for each sector. In doing so, we have been guided by a similar index compiled by the European Bank for Reconstruction and Development for countries in Central and Eastern Europe and reported in the flagship publication _Transition Report 2004_ . This approach starts from a general template of reforms necessary to achieve a desirable policy environment, which is then adapted to the specific situation of each sector.

For each services sector _k_ , the time-varying services reform index _reformkt_ ranges from 0 to a maximum score of 5. An index value of 0 corresponds to a situation where the public sector is either the only relevant provider of services or has a strong grip on private providers, and there is extremely limited scope for the market mechanism. Note that all Indian services sectors treated here fall into this highly restrictive category before the beginning of economic reforms in the early 1990s. A level of 1 indicates at least some scope for private sector participation and some liberalization of operational decisions, combined with some very limited scope for foreign participation (limited, for example, by low FDI ceilings). To qualify for an index value of 2, there must be only a limited degree of interference with operational decisions by public authorities, substantial price liberalization, and clear scope for foreign participation even if only in narrowly defined segments and as minority shareholders. Still, the state may remain a dominant actor in the sector. An index of 3 implies significant scope for private providers, including foreign ones, clear competitive pressure on the public incumbents from new entrants, and explicit possibilities for foreign equity participation. A level of 4 is equivalent to little public intervention and the freedom of operation of private providers, the possibility of majority foreign ownership, and the dominance of private sector entities. Finally, a level of 5 (not attained in any of the sectors considered here) would reflect an equal treatment of foreign and domestic providers, a full convergence of regulation with international standards and unrestricted entry into the sector. The details of how the index was constructed are presented in on-line Appendix B (attached at the end of the manuscript). The index is available for four sectors: banking, telecoms, transport and insurance for the time period 1991-2004.

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# **_Linkages between Manufacturing Industries and Services Sectors_**

The next question in our analysis is how to aggregate these sector-specific indices into a single index of services reform. Given that some services are likely to be more important for manufacturing industries than others, and that this dependence may vary across different manufacturing industries, an unweighted average of services sector indices is unlikely to be an appropriate measure of the potential impact of upstream services liberalization on the performance of manufacturing firms. Instead, we use information on the intensity with which services inputs are used in the production of a given manufacturing sector. In particular, we weight each of the reform indices for the four major services sectors (banking, telecom, transport and insurance) by the proportion _αjk_ of inputs sourced by the manufacturing sector _j_ from the services sector _k_ to create the index of services reform: where _αjk_ is based on the input-output matrix pertaining to 1993, the first year of our sample.<sup>14</sup> Data from a national input-output matrix contain information about the average inter-industry sourcing behavior of firms in a given sector of the economy. For an individual firm, the actual reliance on a given services sector may be somewhat different, but even if such information were available at the level of each individual firm (which it is not), such data would risk being endogenous to the performance of the firm, which would defeat our purpose. By using average information, we lose some precision in measuring the reliance of firms on services inputs, but we can be less concerned about the endogeneity of this measure. The fact that we use sourcing information from the 1993 input-output matrix should further minimize the scope for endogeneity even at the level of the average firm in an industry.

> 14 The input-output matrix includes 66 manufacturing sectors and 16 services sectors. The manufacturing sectors were aggregated to 38 sectors at which sector-specific price deflators were available. The services sectors include:  construction, electricity, gas, water supply, railway transport services, other transport services, storage and warehousing, communication, trade, hotels and restaurants, banking, insurance, ownership of dwellings, education and research, medical and health, other services. Input shares are calculated relative to the total value of inputs sourced.  Banking services constitute on average 5% of all inputs, transport 4.4%, telecommunications 1.6% and insurance 1.4%. An alternative normalization, by gross output, leads to the same conclusions.

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In our analysis, we will also distinguish between the effects of reform in individual services sectors. To do so, we will construct indices capturing the reform in a particular services sector. For instance, we will define where _αj,banking_ reflects the proportion of inputs sourced by the manufacturing sector _j_ from the banking sector, according to the input-output matrix, and _reformbanking,t_ is the state of reform in the banking industry at time _t._ We will follow the same approach to construct indices for telecom, insurance and transport sectors.

For the banking sector, an alternative measure of financial dependence will help us to test the robustness of the main measure. This alternative is based on Rajan and Zingales (1998), who compute sector averages of financial dependence based on US data and argue that this is a suitable measure for firms‟ technologically induced demand for external finance in an environment with well-developed financial markets. The measure is based on a comparison between firms‟ investment outlays and own cash flow.

# **_Measuring the Performance of Manufacturing Firms_**

Our goal is to provide a fuller explanation of the remarkable improvement in the performance of the Indian manufacturing sector following the post-1991 economic reforms. We use firm-level data from the Capitaline database, a commercially available database including balance sheets, profit and loss statements, and ownership information on large private and public firms operating in India to measure the performance of manufacturing firms. The database covers 62 percent of India‟s manufacturing output during the period considered by the analysis, and includes 11,939 firms, of which 5,236 operate in the manufacturing sector. The data set forms an unbalanced panel covering the period 1993-2005. Firms‟ industry affiliations follow India‟s National Industry Classification (NIC) which encompasses the manufacturing sectors. After cleaning the data and discarding firms not reporting information on output or production inputs, we are left with 3,771 firms or 22,558 firm-year observations.

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A consistent measurement of firm performance is crucial to our analysis. We use the total factor productivity (TFP) as our outcome of interest. To control for a possible simultaneity bias arising from the endogeneity of a firm‟s input selection, which will exist if a firm responds to productivity shocks unobservable to the econometrician by adjusting its variable input choices, we follow the method proposed by Ackerberg, Caves and Frazer (2006). Ackerberg et al. build on the widely used estimation procedures proposed by Olley and Pakes (1996) and Levinsohn and Petrin (2003). Unlike the latter method, their approach allows for more plausible assumptions about the timing of the firm‟s decision regarding input choices and optimization errors.

We use the Ackerberg et al. method to estimate sector-specific production functions and obtain the TFP as the residual from this estimation.<sup>15</sup> We group some smaller industries together in order to facilitate the estimation.<sup>16</sup> Following the advice of Ackerberg et al., we use value added as the dependent variable in the production function. Value added is defined as the sales of firm _i_ in year _t_ less the value of material, services and energy inputs. All components of value added are expressed in real terms. Capital and labor inputs (expressed in real terms) are included as independent variables. Material and services inputs (in real terms) are used to proxy for the productivity shocks.

Nominal output is deflated by a set of wholesale price indices disaggregated at the 2-digit level, while capital inputs are calculated from detailed data on net values of land, buildings, machinery and computers, all deflated by the relevant sector deflators. In the absence of data on the number of workers employed, the labor input is calculated by normalizing the wage bill of each firm by the average wage prevailing in a given 2-digit sector in a given year. Materials are deflated by input-output coefficient weighted sector deflators based on the wholesale price index. Energy inputs are deflated using National Accounts Statistics price indices for “Fuel, Power, Light and Lubricants.” Services inputs are aggregated from detailed data on reported expenses on travel, transport, legal services and accounting, and non-interest banking expenses. These items are deflated using a weighted average of services sector deflators from the national accounts statistics. Given that our interest is in upstream services reform, a proper accounting for services inputs at the firm level is essential to control for changes in the intensity with which firms use

> 15 We are grateful to Carolina Villegas-Sanchez for sharing with us a STATA routine implementing the procedure. 16 The industry groupings are: food and tobacco; textiles; garments and leather goods; wood, paper and printing; petroleum products and chemicals; rubber and plastics; non-metallic minerals, iron and steel; metal products; machinery, office, electrical and communication equipment; lifting, medical and industrial equipment; motor vehicles and other transport equipment.

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services in their production, in response to increased product offerings in the service sectors. Summary statistics for all the variables are presented in Table 1.

To establish whether there exists a link between the performance of manufacturing firms and liberalization of upstream services sectors, we regress the TFP of a manufacturing firm _i_ operating in industry _j_ at time _t_ on the aggregated _Services_Indexjt-1_ lagged one period or disaggregated indices of services reform. We control for foreign ownership, trade liberalization, firm and year fixed effects. Our principal estimation equation has the following form: Services sectors were not the only item on the post-1991 reform agenda in India. Continued reductions in manufactured product tariff rates occurring during the same period may also have influenced manufacturing productivity. To control for changes in tariff rates, we include lagged output tariffs in the same manufacturing sector ( _Tariffjt-1_ ) and a weighted measure of input tariffs ( _Input tariffjt-1_ ). The weights of the input tariffs are taken from the 1993 input-output matrix, while the aggregation of individual tariff lines to the 2-digit sector level is achieved using the 1990 import weights. The information on tariffs was obtained from the World Bank‟s WITS database.<sup>17</sup> As many studies find that foreign affiliates tend to outperform domestic producers (see for instance, Aitken and Harrison, 1999; Arnold and Javorcik, 2009), we include an indicator for foreign-owned firms, equal to one if the foreign ownership share in firm _i_ is above 10% at time _t_ ( _Foreignit_ ). In an expanded specification, we will allow for differential effects of services reform on domestic and foreign firms by interacting _Foreignit_ with the _Services_Indexjt-1._ The dependent variable is firm-specific, but our variables of interest vary at the sector-year level, therefore, we cluster standard errors at the sector-year level.

> 17 The authors are grateful to Rajesh Mehta for providing tariff data for the years in which the figures were missing from WITS.

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As a benchmark, we also use OLS to estimate an augmented Cobb-Douglas production function. To make it comparable to the Ackerberg et al. procedure, we regress real firm value added (defined as above) on real labor and capital inputs as well as measures of services reform and other control variables:<sup>18</sup> ln _VAijt_   _i_   1 _j Kit_   2 _j Lit_   3 _Services_ Index jt_  1   4 _Tariffit_  1   5 _Input tariff it_  1   6 _Foreignit_   _t_  _it_ (4) where _VAijt_ stands for the value added of firm _i_ observed in year _t_ (and manufacturing industry _j_ ), _Kit_ denotes capital, and _Lit_ labor. Note that we allow the coefficients on capital and labor inputs to differ across 11 manufacturing sectors. As in specification (3), we include firm and year fixed effects and cluster standard errors at the sector-year level.

Our point estimates for the production function coefficients, presented in Table 2, have reasonable values. On average, the labor coefficient is 0.73 in the OLS and 0.75 in the Ackerberg et al. specification, and the capital coefficient is equal to 0.27 in both cases. In 9 of 11 industries, the coefficient on the capital input is higher in Ackerberg et al. procedure, which is what we would expect to observe under plausible assumptions (Olley and Pakes, 1996). The average returns to scale are very close to constant (1.00 and 1.01).

> 18 A specification with output on the left-hand side and industry-specific coefficients on material inputs, services inputs and energy leads to very similar results.

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# **V. Results**

# **_Baseline Specification_**

Our baseline regression results from estimating equation (4) are presented in Table 3. We find that the aggregate services index has a positive and highly significant coefficient estimate, suggesting a strong role for services liberalization in explaining manufacturing firm productivity in India. A one-standarddeviation change in the aggregate services index improves manufacturing productivity on average by 9.1 percent.

We also enter the individual service sector reform indices into the regression one by one. We find positive and statistically significant effects of banking, telecom and transport reforms. For banking, both our standard input-output weighted index and the Rajan-Zingales weighted measure yield similarly significant results. There is no evidence that liberalization of the insurance industry led to a better performance of manufacturing firms.

When we enter the individual sector indices simultaneously (column 7 of Table 3), the banking, the telecom and the transport index maintain their positive and significant coefficients. The results from this regression suggest that telecom and transport liberalization have the strongest effects on productivity. A one-standard-deviation increase in liberalization of the telecom industry yields a 8.8 percent increase in productivity, and a one-standard-deviation change in transport improves productivity by 14 percent. Banking reform has a 4.4 percent productivity effect, while the effect for the insurance sector is not significant at the conventional levels.

Alternatively, we can focus on the magnitude of the effect corresponding to a one-unit change in the value of the liberalization index. For instance, allowing firms greater operational autonomy and enhancing scope of foreign participation (change in the index from one to two) leads to a productivity increase of 1.7 percent when the banking sector is reformed, 2.7 percent when the telecom sector is liberalized and 19 percent when the change pertains to the transport industry.

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Over the period of our sample, we cannot identify a significant effect from changes in tariff rates on manufacturing productivity.<sup>19</sup> We also find that foreign affiliates tend to exhibit higher productivity than domestic firms which is consistent with the conclusions of the existing literature (Aitken and Harrison, 1999; Arnold and Javorcik, 2009).

In Table 4, we present the results with our preferred TFP measure estimated based on the Ackerberg et al. method. We first apply this method to estimate production functions for each of the 11 sectors separately, and then we regress the TFP obtained from these regressions on services and trade liberalization variables, the foreign affiliate dummy as well as firm and year fixed effects. Using the Ackerberg et al. measure leads to three changes in the results. First, the estimated coefficients become larger while maintaining their significance levels. Second, the insurance index, which did not reach conventional significance levels in Table 3, now appears to be statistically significant at the 10 percent level in one specification. Third, the transport index now appears to be statistically significant in both specifications where individual measures of services reform enter jointly.

When the individual services sectors are examined in the last column of Table 4, a one-standard-deviation change in the banking sector index corresponds to a 6.6 percent change in productivity. A one-standarddeviation change in the telecommunications liberalization index corresponds to a 8.4 percent increase in productivity. A similar change in the transport index leads to a 18.8 percent improvement in firm performance. No statistically significant effect is found for the insurance sector reform. As before, the coefficients on tariffs do not appear to be statistically significant.<sup>20</sup>

# **_Do Foreign Firms Benefit More from Services Liberalization?_**

Our finding of a significant productivity premium for foreign owned firms is common in the literature. But does ownership also affect the ability of firms to reap the benefits of upstream services reform? Liberalization allows entry of foreign services firms which may have stronger links with foreign-owned

> 19 In a recent paper, Bollard, Klenow and Sharma (2010) also find that productivity growth in Indian manufacturing since the 1990s is not robustly related to tariff reductions. It is also possible that we do not find significant effects because most of the tariff cuts took place prior to the time covered by our sample.

> 20 In regressions, not reported to save space, we also show that our conclusions are robust to using a translog production function.

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manufacturing firms and whose local presence could therefore provide greater benefits to foreign-owned manufacturing firms. Moreover, accustomed to doing business in environments with well-developed services sectors, foreign firms may derive larger benefits from improvements in services industries. In order to test this hypothesis, we estimate an expanded specification which includes interaction effects between the services index and the foreign ownership indicator.

The interaction between foreign ownership and services liberalization is positive and significant for the aggregate measure (see Table 5). This is also true in all cases when services indices enter one by one, confirming our intuition that the productivity effect of services liberalization is stronger for foreign owned firms. This increased effect for foreign owned firms is consistent across services sectors when tested individually, but is not significant for the banking and the transport sector when all services indices enter the same model. This may be because multinational firms are relatively well-equipped able to procure banking and transport services internationally, and are therefore less reliant on the respective domestic sectors.

The differential impact of liberalization on foreign firms is remarkably strong in the telecommunications sector. A standard deviation increase in the telecommunications index increases productivity by 7.2 percent for domestic firms while it increases productivity by 9.8 percent for foreign owned firms. Given the greater need for coordination across national borders, one may find this result intuitive. As for the insurance reform, only foreign firms seem to be able to appropriate its benefits and see a boost in productivity of 3.3 percent.

# **_Controlling for Other Reforms_**

While many observers have considered decreasing tariff protection to be the key explanation behind the productivity enhancements of Indian firms, recent research suggests that a comprehensive approach may be warranted, encompassing also other policy changes taking place in India (Harrison et al., 2011). Against this background, we extend the set of controls in our baseline specification to include industry23
specific measures of de-licensing and FDI reform.<sup>21</sup> We do not take into account the labor market reform, most of which occurred before the first year of our sample 1993 (Ahsan and Pagés, 2009).

To capture the effects of the de-licensing reforms, we use information from Harrison et al. (2011), who extended the data used by Aghion et al. (2008) to 2004, on the basis of Press Notes from the Ministry of Commerce and Industry. The de-licensing variable is a dummy that takes on a value of one if any products in a 3-digit industry have been de-licensed, and zero otherwise. Similarly, the measure of FDI reform was compiled by Harrison et al. (2011) also based on Press Notes from the Ministry of Commerce and Industry. It takes on a value of one if any products in a 3-digit industry have been liberalized, and zero otherwise.<sup>22</sup> In Table 6, we present the results from the modified specification. We find a positive correlation between de-licensing and FDI reform and firm productivity. More importantly for the purposes of this paper, our results on services reform are barely affected by this change.<sup>23</sup>

# **_Instrumenting the Services Liberalization Index_**

In order to ensure that our finding of services reforms improving manufacturing performance is not driven by reverse causality, we instrument the index of services reform. The intuition behind our instrumental variables (IV) approach is that India will react to services liberalization undertaken by other countries, especially economies it views as its competitors, such as China and Indonesia. We measure services liberalization using the WTO commitments in a given sector. More specifically, we focus on the number of commitments made by a country expressed as a percentage of possible commitments. For the years prior to the first full year of the WTO membership of a given country (e.g. 2002 for China), the number of commitments equals zero. To create an instrument relevant to a particular manufacturing sector, the

> 21 According to Harrison et al, by the end of 1991, nearly 85% of industries had been de-licensed, with the share increasing to over 90% of industries by the end of the 1990s. The FDI liberalization occurred somewhat more slowly, and only in 2000 all industries became eligible for automatic FDI approval, except those requiring an industrial license or meeting several other conditions.

> 22 We are very grateful to Ann Harrison, Leslie Martin and Shanthi Nataraj for sharing the data with us.  Industries have been converted from 3-digit NIC 87 industry codes to 4-digit NIC98 industry codes.  Where direct correspondences were not found, averages were used at the 2-digit NIC98 level.

> 23 Including these additional controls in all other specifications presented in the paper would not change its conclusions.

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measure of services liberalization is multiplied by the proportion αjk of inputs sourced by the manufacturing sector _j_ from the services sector _k_ , as with the services index in equation 1. In this way we create two instruments: (i) pertaining to China's commitments and (ii) pertaining to Indonesia's commitments. Each instrument varies by time, manufacturing industry and services sector. An alternative specification, using instead the commitments of all WTO members yielded similar results (available upon request).

The results from IV regressions are reported in Table 7. As expected, the first stage results indicate that Indian services reform responded to services liberalization in China and Indonesia. The F-statistics suggest that our instruments perform well. The Sargan test does not cast doubt on their validity with the exception of the specification focusing on the transport sector. The second stage confirms our earlier finding that services reforms have improved manufacturing performance. This gives us confidence that reverse causation is not driving our results.

# **_Alternative Measure of Service Reform_**

While the construction of our services reform index was undertaken with great care and confirmed by extensive consultations with sector experts in India, a composite index is by its very nature always prone to measurement imperfections. We therefore wish to check the robustness of our findings to more parsimonious approaches to measuring services reform. Although a “true” measure of policy reform does not exist, it may be possible to identify the key structural break points in policy regimes with greater objectivity than is involved in the construction of a composite index that reflects a judgment of the relative importance of specific reforms. Hence we check the previous findings by using a simpler measure of structural breaks for each services sector.<sup>24</sup> This is done by identifying the year in which a service sector experienced the most transformative policy reform and generating a simple indicator variable that divides years into “before” and “after” this structural break. These policy cornerstones in services sectors are then weighted by the input-output coefficients linking services and manufacturing sectors, in the same way as with the policy index: _Breakjt = ajkIkt_ (5)

> 24 Note that it is not possible to do this for the aggregate measure as the timing of structural breaks varies from sector to sector.

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where _αjk_ is the share of inputs sourced from services sector _k_ by manufacturing sector _j_ , and _Ikt_ is an indicator variable for services sector _k_ taking on the value of one if an observation pertains to the year of the structural break year or a later period, and zero otherwise.

The structural breaks were determined as follows. The most important reforms in the banking sector occurred in 2001, when there was full deregulation of the interest rates and banks were allowed greater flexibility in choosing borrowers and designing loan terms. Liberalization of the banking sector allowed for improved allocation of credit and increased investment by private and foreign banks.

The most important reforms in the telecommunications sector in India occurred in 2002, when the government terminated the VSNL (publicly owned telecommunications company) monopoly and allowed free entry into the long distance sector. This policy reform in the telecommunications sector quickly led to entry in the sector and intense competition.

For transportation, the most important reform came in 1997 when increased privatization in port management was allowed. Approval was granted for up to 74 percent foreign ownership in port management, foreign and private investment in construction, and increased private and foreign investment in aviation. The effect was to make the transportation industry more competitive, which translated into gains in the speed with which processes were completed at ports and deliveries were made.

In the insurance industry, 2002 is the most important year of reform, as it marked the registration of sixteen new providers, and permission for twelve new insurance providers to enter the market. Yet the insurance reforms were slower to be instituted than the other services reforms.

The results obtained from replacing the services index in equation (4) with the variable _Breakjt_ pertaining to individual services industries confirm our earlier findings (Table 8). Important policy changes in services sectors appear to have left their mark on the performance of manufacturing firms dependent on services inputs. Strong productivity effects can be identified from the banking, telecommunications, insurance and transport sectors, and as in the index regressions, the coefficients are particularly large for the telecom and transport sectors. Again when measures for several services industries enter jointly, the 26
insurance measure loses its statistical significance. As is evident from Table 9, these regressions also confirm that there is a stronger productivity effect on foreign firms than on domestic firms.

# **_Liberalization Year Falsification Test_**

In order to ensure that the liberalization measures identify effects of reforms rather than spurious effects from broader industry-level productivity trends, we test the liberalization discontinuity effect on years prior to the reform. If the effect captured by the liberalization breaks were simply related to industry trends, we would expect the coefficient on years prior to the reform to be as large and significant as the coefficient on our variable of interest.

To implement this test we create a new variable _1 year prior to breakjt = ajkIPkt_ where _αjk_ is the share of inputs sourced from services sector _k_ by manufacturing sector _j_ , and _IPkt_ is an indicator variable for services sector _k_ taking on the value of one in the year prior to the year of the structural break, and zero otherwise. We also define an analogous variable for the two-year period preceding the structural break which we use in an alternative specification.

As is evident from Table 10, we find that in each industry the coefficient on the break in the year of reform is larger and significantly different from the coefficient on the years preceding the reform. The results are somewhat weaker in the second specification for the transport reform (the last column) where the p-value of the test equal 0.126. Only in 3 of 10 specifications is the coefficient on the falsification variable positive and statistically significant.

# **_Other Robustness Checks_**

A potential concern is that the service indices increase monotonically over time. This makes the empirical strategy susceptible to picking up spurious sectoral trends. If the sectors that are intensive in the more 27
reformed services were more dynamic and productivity grew in these sectors for reasons unrelated to input improvements, we could get the results obtained so far even in the absence of a true effect of services liberalization on firm performance.

To address this concern, we replace year fixed effects with sector-specific time trends (we use the sector aggregation presented in Table 2). The results, presented in Table 11, confirm our earlier findings. We find a positive link between the aggregate measure of services reform and the performance of downstream manufacturing firms. As before, larger benefits appear to accrue to foreign affiliates. A similar pattern is detected for the banking reform. When it comes to the telecom, insurance and transport sectors, the benefits of services liberalization appear to accrue only to foreign firms. The magnitudes of the effects are similar to those found in Table 5 and are statistically significant at the 1 percent level.

Finally, we examine whether our results are subject to an autocorrelation problem that could lead to the underestimation of standard errors, as discussed by Bertrand et al. (2004). To check for this potential estimation bias, we take their advice and ignore the time-series information when computing standard errors. We perform the test in three steps. First, we regress the logarithm of TFP on control variables (other than the services variables) and fixed effects and keep the residuals. Second, we divide the residuals into two groups: residuals from the years before the structural break and residuals from the postbreak period and calculate a within-firm average for each period. In the last step, we regress the twoperiod panel of mean residuals on the _Breakjt_ variable defined in equation (5). We cluster standard errors for each manufacturing industry. We repeat the procedure for a break in each services sector considered in the analysis.

As is evident from Table 12, we find positive and statistically significant (at the 1 percent level) effects for the banking sector, telecoms and insurance reform. Somewhat surprisingly, we obtain a negative coefficient for the transport reform. Given these findings, we feel reasonably confident that our baseline results are not subject to the autocorrelation problem.

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# **VI. Conclusions**

This paper suggests that previous explanations for the post-1991 growth of India‟s manufacturing sector have ignored an important factor: the contribution of India‟s policy reforms in services. By gathering detailed information on the pace of policy reform in Indian services sectors and constructing a series of reform indices, we demonstrate a strong and significant empirical link between progress in policy reforms in services sectors and productivity in manufacturing industries. Our findings are robust to a number of checks, including instrumenting for the pace of reform in Indian services sectors, controlling for trade liberalization, foreign ownership, sector-specific time trends and autocorrelation. We also investigate the relative contribution of reform in each of the services sectors to the productivity of manufacturing firms, and find that liberalization in the banking and telecommunications sectors had the most robust productivity effects on manufacturing firms over the period. When distinguishing the effect of services reform by ownership, we find that foreign-owned subsidiaries in India display an even greater ability to reap the benefits of services reforms than domestic firms.

The particularly robust effects of banking and telecommunications liberalization are intuitive results. Liberalization in the banking sector has improved capital allocation and allowed investment in higher return projects. Liberalization of the telecommunications sector has interacted with technological change not only to enhance the reliability and reduce the cost of communication, but it has also paved the way for entirely new ways of communication and organizing production. Liberalization of the transport sector allows easier and less expensive transportation of raw materials and goods for export. However, reforms in several areas of the transportation sector in India have been slow, and some control over transport remains at the state level. Given that we cannot capture this state-level variation in our index, the results for the transportation sector seem somewhat weaker, although significant in a number of specifications. Insurance sector reforms do not appear to have had a strong influence in our data, possibly due to their limited scope so far.

Services reforms in India remain incomplete and barriers to domestic and foreign competition exist in many other countries. This paper suggests that in addition to retarding the development of the services sectors, these barriers also penalize the manufacturing sector. Wider appreciation of this link may help create broader political support for services reform. It may also provide greater perspective for 29
international trade negotiations, which only notionally address impediments to services trade and investment and continue for the most part to focus on goods – agriculture and manufacturing.

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- Goldberg, Penny, Amit Khandelwal, Nina Pavcnik, and Petia Topalova (2009). "Trade Liberalization and New Imported Inputs," _American Economic Review Papers & Proceedings_ 99(2): 494-500.

- Goldberg, Penny, Amit Khandelwal, Nina Pavcnik, and Petia Topalova (2011a). “Imported Intermediate Inputs and Domestic Product Growth: Evidence from India,” _Quarterly Journal of Economics_ , forthcoming.Goldberg, Penny, Amit Khandelwal, Nina Pavcnik, and Petia Topalova (2011b).  “Multi-Product Firms and Product Turnover in the Developing World:  Evidence from India.” _Review of Economics and Statistics_ , forthcoming.

- Gordon, James and Poonam Gupta (2004).  “Understanding India‟s Services Revolution.”  IMF Working Paper #171.

- Grossman, G. and E. Helpman (1991). _Innovation and Growth in the Global Economy_ . MIT Pres.

- Halpern, László, Miklós Koren and Adam Szeidl (2009). “Imported Inputs and Productivity,” mimeo, University of California Berkeley.

- Harrison, Ann, Leslie Martin and Shanthi Nataraj (2011). “Learning versus Stealing: How Important Are Market Share Reallocations to India‟s Productivity Growth?” RAND Working Paper WR-832.

- Hoekman, Bernard, Aaditya Mattoo, and Andre Sapir (2007). “The political economy of services trade liberalization: a case for international regulatory cooperation?” _Oxford Review of Economic Policy_ 23(3) 367-391.

- “Insurance: Indian and Foreign firms test positive for Growth Steroid.” _India Knowledge@Wharton_ , November 16, 2006.

Insurance Development and Regulatory Authority, _Annual Report 2004_ . www.irdaindia.org.

- Javorcik, Beata S. (2004) “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers through Backward Linkages” _American Economic Review_ 94(3).

- Jones, Chad (2011). “Intermediate Goods and Weak Links in the Theory of Economic Development” _American Economic Journal: Macroeconomics_ 3: 1–28.

- Khandelwal, Amit and Petia Topalova (2011) "Trade Liberalization and Firm Productivity: The Case of India" Review of Economics and Statistics 93(3):995-1009.

- Li, Yue and Beata S. Javorcik (2008). "Do the Biggest Aisles Serve a Brighter Future? Global Retail Chains and Their Implications for Romania," CEPR Discussion Papers 6906.

- Levinsohn, James and Amil Petrin (2003). “Estimating Production Functions Using Inputs to Control for Unobservables.” _Review of Economic Studies_ 70(2): 317-341

- Krishna, Pravin and Devashish Mitra (1998) “Trade Liberalization, Market Discipline and Productivity Growth: New Evidence from India.” _Journal of Development Economics_ 56 447-462.

- Markusen, J.R. (1989). “Trade in Producer Services and in Other Specialized Intermediate Inputs” _American Economic Review_ 77: 85-95.

32
- Mattoo, Aaditya, Randeep Rathindran and Arvind Subramanian (2006). “Measuring Services Trade Liberalization and its Impact on Economic Growth: an Illustration.” _Journal of Economic Integration_ 21: 64-98.

- Ministry of Commerce and Industry(2008). Indiastat.

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OECD (2011). _Economic Survey of India_ , OECD Publishing, Paris, France

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- Pavcnik, Nina (2002) “Trade Liberalization, Exit, and Productivity Improvement: Evidence from Chilean Plants,” _Review of Economic Studies_ 69(1), 245-76.

- Rajan, Raghuram G. and Luigi Zingales (1998). “Financial Dependence and Growth.” _American Economic Review_ 88: 559-586.

- Reddy, Y.V. (2002). “Monetary and financial sector reforms in India: a practitioner‟s perspective.” Bank for International Settlements, http://www.bis.org/review/r020425d.pdf.

- Reddy, Y.V. (2005). “Banking Sector Reforms in India-an Overview” Bank for International Settlements, http://www.bis.org/review/r050519b.pdf.

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- http://www.rbi.org.in/scripts/statistics.aspx.

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33
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# **Tables**

## **Table 1:  Summary Statistics**

|Variable|Obs|Mean|Std. Dev.|
|---|---|---|---|
|ln TFP Ackerberg et al.|22558|1.53|1.10|
|ln Output|22558|2.57|2.01|
|ln Energy|22558|-0.12|2.04|
|ln Capital|22558|2.52|1.77|
|ln Labor|22558|0.45|1.79|
|ln Material inputs|22558|2.62|1.90|
|ln Services inputs|22302|0.27|1.92|
|Services Index lagged|22558|0.18|0.10|
|Banking Index lagged|22558|0.06|0.07|
|Rajan Zingales Banking Index lagged|22558|0.71|0.74|
|Telecom Index lagged|22558|0.02|0.02|
|Insurance Index|22558|0.01|0.02|
|Transport Index lagged|22558|0.10|0.04|
|Foreign Dummy|22558|0.18|0.38|
|Tariff lagged|22558|36.47|17.17|
|Input Tariff lagged|22558|16.41|9.38|
|De-licensing lagged|22558|0.97|0.15|
|FDI reform lagged|22558|0.87|0.33|

**Table 2: Production function coefficients**

||OLS<br>|||Ackerberg et al.<br> <br>||
|---|---|---|---|---|---|
||Capital|Labor|Sum|Capital<br>Labor|Sum|
|Food processing and tobacco products|0.155|0.682|0.837|0.166<br>0.829|0.995|
|Textiles|0.345|0.604|0.949|0.357<br>0.543|0.900|
|Garments, leather goods and shoes|1.002|0.707|1.709|0.074<br>0.898|0.972|
|Wood products, paper products, printing and<br>publishing|0.116|0.864|0.980|0.302<br>0.780|1.081|
|Coke, fuel, petroleum and chemicals|0.216|0.616|0.832|0.295<br>0.811|1.106|
|Plastic and rubber products|0.326|0.660|0.986|0.261<br>0.778|1.039|
|Concrete, cement and glass|0.139|0.735|0.874|0.437<br>0.651|1.089|
|Iron and steel|0.211|0.611|0.822|0.257<br>0.677|0.934|
|Metal products, machinery and tools|0.056|0.832|0.888|0.145<br>0.831|0.975|
|Lifting, medical and industrial equipment|0.189|0.824|1.013|0.325<br>0.678|1.003|
|Motor vehicles and transport systems|0.218|0.870|1.088|0.312<br>0.745|1.058|

37
# **Table 3:  Productivity Effects of Services Liberalization. OLS Approach**

|Services Index(t-1)|0.875***<br>(0.228)|||||||
|---|---|---|---|---|---|---|---|
|Banking Index(t-1)||0.765***|||||0.620***|
|||(0.246)|||||(0.239)|
|Banking Index Rajan-Zingales|||0.164***|||||
|weights(t-1)|||(0.033)|||||
|Telecom Index(t-1)||||4.594***|||4.215***|
|||||(1.354)|||(1.320)|
|Insurance Index(t-1)|||||0.933||0.322|
||||||(0.930)||(0.954)|
|Transport Index(t-1)||||||2.921*|3.282**|
|||||||(1.587)|(1.548)|
|Tariffs(t-1)|0.001|0.000|0.002|0.000|0.000|0.000|0.001|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|-0.002|-0.002|-0.003|0.001|-0.002|-0.004|-0.002|
||(0.008)|(0.008)|(0.008)|(0.008)|(0.008)|(0.007)|(0.007)|
|Foreign|0.040**|0.041**|0.041***|0.042***|0.044***|0.046***|0.041***|
||(0.016)|(0.016)|(0.016)|(0.016)|(0.016)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.257|0.256|0.259|0.257|0.255|0.256|0.258|
|Number of firms|3771|3771|3771|3771|3771|3771|3771|

Notes: The estimated specification is described in equation (4) in the text. The dependent variable is the log of real firm value added. Explanatory variables include capital and labor, all expressed in real terms and logs. Coefficients on production inputs are allowed to vary for each of 11 sectors. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 38
# **Table 4:  Productivity Effects of Services Liberalization. Ackerberg et al. TFP Measure**

|Services Index(t-1)|1.171***<br>(0.227)|||||||
|---|---|---|---|---|---|---|---|
|Banking Index(t-1)||1.046***|||||0.911***|
|||(0.249)|||||(0.245)|
|Banking Index Rajan-Zingales|||0.194***|||||
|weights(t-1)|||(0.032)|||||
|Telecom Index(t-1)||||4.765***|||4.037***|
|||||(1.281)|||(1.213)|
|Insurance Index(t-1)|||||1.649*||0.853|
||||||(0.952)||(0.994)|
|Transport Index(t-1)||||||3.675**|4.300**|
|||||||(1.702)|(1.660)|
|Tariffs(t-1)|0.001|0.000|0.003|0.000|0.000|0.000|0.001|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|-0.003|-0.003|-0.004|-0.001|-0.003|-0.007|-0.004|
||(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.008)|(0.007)|
|Foreign|0.027|0.029*|0.030*|0.033**|0.035**|0.041**|0.032**|
||(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.032|0.030|0.035|0.030|0.028|0.029|0.034|
|Number of firms|3771|3771|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 39
**Table 5:  Differential Effect of Services Liberalization on Foreign Firms. Ackerberg et al. TFP Measure**

|Services Index(t-1)|1.106***<br>(0.236)|||||||
|---|---|---|---|---|---|---|---|
|Services Index(t-1)* Foreign|0.135**<br>(0.063)|||||||
|Banking Index(t-1)||0.932***<br>(0.264)|||||0.896***<br>(0.263)|
|Banking Index(t-1)* Foreign||0.239**<br>(0.115)|||||0.035<br>(0.124)|
|Banking Index Rajan-Zingales|||0.182***|||||
|weights(t-1)|||(0.034)|||||
|Banking Index Rajan-Zingales|||0.026**|||||
|weights(t-1)* Foreign|||(0.012)|||||
|||||4.000***|||3.454**|
|Telecom Index(t-1)||||<br>(1.391)|||<br>(1.337)|
|||||<br>1.442***|||<br>1.198**|
|Telecom Index(t-1)* Foreign||||(0.454)|||(0.554)|
|Insurance Index(t-1)|||||0.914<br>(0.955)||0.277<br>(0.955)|
||||||2061***||1630***|
|Insurance Index(t-1)* Foreign|||||.<br>(0.449)||.<br>(0.508)|
|||||||3.659**|4.347***|
|Transport Index(t-1)||||||<br>(1.700)|<br>(1.656)|
|||||||<br>0.258*|<br>-0.225|
|Transport Index(t-1)* Foreign||||||(0.135)|(0.160)|
|Tariffs(t-1)|0.001|0.000|0.003|0.000|0.000|0.000|0.001|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|-0.003|-0.003|-0.004|-0.001|-0.003|-0.007|-0.004|
||(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.008)|(0.007)|
||0.017|0.021|0.021|0.023|0.024|0.032**|0.021|
|Foreign|(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.032|0.030|0.035|0.030|0.028|0.029|0.035|
|Number of firms|3771|3771|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 40
**Table 6:  Controlling for De-licensing and FDI Reform. Ackerberg et al. TFP Measure**

|Services Index(t-1)<br>|1.285***<br>(0.229)|||||||
|---|---|---|---|---|---|---|---|
|Banking Index(t-1)||1.212***|||||1.010***|
|||(0.249)|||||(0.242)|
|Banking Index Rajan-||||||||
|Zingales weights(t-1)|||0.190***|||||
||||(0.031)|||||
|Telecom Index(t-1)||||5.025***|||4.097***|
|||||(1.328)|||(1.258)|
|Insurance Index(t-1)|||||2.211**||1.118|
||||||(0.978)||(0.995)|
|Transport Index(t-1)||||||2.986*|3.569**|
|||||||(1.550)|(1.466)|
|Tariffs(t-1)|-0.001|-0.001|0.001|-0.001|-0.002|-0.001|-0.000|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|-0.004|-0.004|-0.005|-0.001|-0.004|-0.007|-0.004|
||(0.008)|(0.008)|(0.008)|(0.008)|(0.009)|(0.008)|(0.007)|
|De-licensing(t-1)|0.243**|0.217**|0.212*|0.231**|0.217**|0.244**|0.279**|
||(0.110)|(0.109)|(0.109)|(0.111)|(0.109)|(0.110)|(0.113)|
|FDI reform(t-1)|0.167***|0.173***|0.139**|0.152**|0.164**|0.112*|0.134**|
||(0.064)|(0.065)|(0.064)|(0.066)|(0.065)|(0.057)|(0.057)|
|Foreign|0.030*|0.030*|0.033**|0.036**|0.037**|0.043***|0.033**|
||(0.017)|(0.017)|(0.016)|(0.016)|(0.017)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.036|0.034|0.038|0.033|0.032|0.032|0.037|
|Number of firms|3,771|3,771|3,771|3,771|3,771|3,771|3,771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 41
# **Table 7:  Productivity Effects of Services Liberalization. Instrumental variables approach using Ackerberg et al. TFP**

|**Second stage regressions**||||||||
|---|---|---|---|---|---|---|---|
|Services Index(t-1)|1.277***<br>(0.260)|||||||
|Banking Index(t-1)||1.061***<br>(0.247)|||||0.864***<br>(0.280)|
|Banking Index Rajan-Zingales weights(t-1)|||0.224***<br>(0.056)|||||
|Telecom Index(t-1)||||5.459***<br>(1.469)|||4.199***<br>(1.507)|
||||||2527**||2646*|
|Insurance Index(t-1)|||||.<br>(1.139)||.<br>(1.500)|
|Transport Index(t-1)||||||6.891<br>(4.206)|10.174**<br>(4.288)|
|Tiff|0.0009|0.0004|0.0030|0.0004|0.0002|0.0002|0.0019|
|ars(t-1)|(0.0018)|(0.0017)|(0.0019)|(0.0018)|(0.0018)|(0.0016)|(0.0018)|
|I Tiff|-0.0031|-0.0035|-0.0042|-0.0001|-0.0030|-0.0094|-0.0079|
|nput ars(t-1)|(0.0090)|(0.0093)|(0.0089)|(0.0090)|(0.0093)|(0.0067)|(0.0059)|
|Fi|0.027|0.029**|0.030*|0.032*|0.034**|0.045***|0.038**|
|oregn|(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.016)|(0.0160)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.032|0.030|0.035|0.030|0.028|0.028|0.029|
|Number of firms|3771|3771|3771|3771|3771|3771|3771|
|**First stage regressions**||||||||
|WTO commitments – China|2.970***|3.746***|<br>17.665***|1.471***|2.645***|0.675***||
||(0.229)|(0.288)|(2.282)|(0.199)|(0.598)|(0.196)||
|WTO commitments – Indonesia|0.564***|<br>0.210**|1.675|2.117***|<br>0.398**|4.972***||
||(0.141)|(0.120)|(1.665)|(0.146)|(0.198)|(0.941)||
|Tariffs(t-1)|0.0003|-0.0001|-0.0122***|<br>-0.0000|-0.0000|0.0001||
||(0.0003)|(0.0001)|(0.0018)|(0.0000)|(0.0000)|(0.0001)||
|Input Tariffs(t-1)|0.0006|0.0001|0.0044|-0.0000|-0.0000|0.0004||
||(0.0005)|(0.0001)|(0.0074)|(0.0001)|(0.0001)|(0.0003)||
|Foreign|0.003***|<br>0.001**|-0.001|0.000|0.000*|-0.001||
||(0.001)|(0.000)|(0.009)|(0.000)|(0.000)|(0.000)||
|**Test statistics**||||||||
|F-stat|129.470|151.650|34.440|291.620|16.590|50.410|20.690|
|p-value|0.000|0.000|0.000|0.000|0.000|0.000|0.000|
|Sargan test|0.068|0.216|0.322|0.763|1.561|6.040|5.345|
|p-value|0.795|0.642|0.570|0.382|0.212|0.014|0.254|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level.

42
**Table 8:  Productivity Effect of Services Liberalization, Structural Break Approach. Ackerberg et al. TFP measure**

|Banking Break 2001|2.626***|||||2.269***|
|---|---|---|---|---|---|---|
||(0.641)|||||(0.549)|
|Rajan-Zingales Break 2001||0.484***|||||
|||(0.081)|||||
|Telecom Break 2002|||8.126***|||6.226***|
||||(2.347)|||(2.223)|
|Insurance Break 2002||||5.218**||3.015|
|||||(2.227)||(1.937)|
|Transport Break 1997|||||8.103***|8.528***|
||||||(2.628)|(2.633)|
|Tariffs|0.000|0.003|0.000|0.000|-0.000|0.001|
|(t-1)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs|-0.004|-0.004|-0.003|-0.003|-0.010|-0.009|
|(t-1)|(0.009)|(0.009)|(0.009)|(0.009)|(0.007)|(0.006)|
|Forein Dumm|0.029*|0.030*|0.034**|0.035**|0.043***|0.034**|
|g y|(0.017)|(0.017)|(0.017)|(0.017)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.030|0.034|0.029|0.028|0.032|0.036|
|Number of firms|3771|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 43
**Table 9:  Productivity Effect of Services Liberalization, Structural Break Approach. Differential Effect of Services Liberalization on Foreign Firms. Ackerberg et al. TFP Measure**

|Banking Break 2001|2.376***<br>(0.667)|||||2.318***<br>(0.592)|
|---|---|---|---|---|---|---|
|Banking Break 2001 *Foreign|0.649*<br>(0.384)|||||-0.179<br>(0.376)|
|Rajan-Zingales Break 2001||0.449***<br>(0.085)|||||
|Rajan-Zingales Break 2001*<br>||0.097**|||||
|Foreign||(0.046)|||||
|Telecom Break 2002|||6.145**|||4.962*|
||||(2.670)|||(2.626)|
|Telecom Break 2002*Foreign|||5.484***|||3.418|
||||(1.965)|||(2.256)|
|Insurance Break 2002||||3.558*||1.934|
|||||(2.122)||(1.818)|
|Insurance Break 2002*Foreign||||4.884***||3.266**|
|||||(1.184)||(1.369)|
|Transport Break 1997|||||7.983***|8.433***|
||||||(2.640)|(2.640)|
|Transport Break 1997*Foreign|||||1.306***<br>(0.481)|0.989**<br>(0.471)|
|Tariffs1|0.000|0.003|0.000|0.000|-0.000|0.001|
|(t-)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Inut Tariffs|-0.004|-0.004|-0.003|-0.003|-0.010|-0.009|
|p(t-1)|(0.009)|(0.009)|(0.009)|(0.009)|(0.007)|(0.007)|
|Forein Dumm|0.019|0.012|0.018|0.019|-0.013|-0.025|
|g y|(0.017)|(0.018)|(0.017)|(0.017)|(0.024)|(0.024)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.030|0.034|0.030|0.029|0.032|0.037|
|Number of firms|3771|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 44
**Table 10: Break falsification test. Ackerberg et al. TFP Measure**

||Banking<br>break|Banking<br>break|Banking break<br>(Rajan-<br>Zingales)|Banking break<br>(Rajan-<br>Zingales)|Telecom break|Telecom break|Insurance<br>break|Insurance<br>break|Transport<br>break|Transport<br>break|
|---|---|---|---|---|---|---|---|---|---|---|
||2001|2001|2001|2001|2002|2002|2002|2002|1997|1997|
|Break|2.610***|2.480***|0.528***|0.558***|9.125***|9.794***|5.198**|3.890|8.053***|7.427***|
||(0.662)|(0.706)|(0.084)|(0.091)|(2.528)|(2.605)|(2.345)|(2.417)|(2.635)|(2.633)|
|Falsification test: 1|-0.070||0.180||4.565*||-0.099||0.381||
|year prior to break|(1.171)||(0.129)||(2.763)||(1.836)||(1.259)||
|Falsification test: 2||-0.330||0.161*||4.070||-3.378*||2.700*|
|years prior to break||(0.854)||(0.095)||(2.765)||(1.961)||(1.397)|
|Tariffs(t-1)|0.000|0.000|0.003|0.003*|0.001|0.000|0.000|0.000|-0.000|-0.000|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|-0.004|-0.004|-0.004|-0.004|-0.003|-0.002|-0.003|-0.003|-0.010|-0.010|
||(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.009)|(0.007)|(0.007)|
|Foreign Dummy|0.029*|0.029*|0.029*|0.029*|0.033**|0.033**|0.035**|0.036**|0.043***|0.044***|
||(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.017)|(0.016)|(0.016)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.030|0.030|0.035|0.035|0.030|0.030|0.028|0.028|0.032|0.033|
|Break coeff = year(s|) prior coeff||||||||||
|F-stat|5.21|10.74|7.2|17.09|2.91|4.39|5.02|7.57|6.59|2.36|
|p-value|0.023|0.001|0.008|0.000|0.089|0.037|0.026|0.006|0.011|0.126|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm and year fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level.

45
**Table 11:  Differential Effect of Services Liberalization on Foreign Firms. Ackerberg et al. TFP Measure. Adding Industry Time Trends**

|Services Index(t-1)|0.921***<br>(0.300)|||||||
|---|---|---|---|---|---|---|---|
|Services Index(t-1)* Foreign|0.183***<br>(0.061)|||||||
|Banking Index(t-1)||0.978***<br>(0.331)|||||1.184***<br>(0.333)|
|Banking Index(t-1)*Foreign||0.273**<br>(0.109)|||||-0.025<br>(0.128)|
|Banking Index Rajan-Zingales|||0.108***|||||
|weights(t-1)|||(0.039)|||||
|Banking Index Rajan-Zingales|||0.040***|||||
|weights(t-1)* Foreign|||(0.011)|||||
|Telecom Index(t-1)||||0.339<br>(1.872)|||-1.110<br>(1.876)|
|Telecom Index(t-1)* Foreign||||1.316***<br>(0.442)|||0.918*<br>(0.550)|
|Insurance Index(t-1)|||||1.841<br>(1.739)||2.519<br>(1.958)|
|Insurance Index(t-1)* Foreign|||||2.257***<br>(0.492)||1.909***<br>(0.594)|
|Transport Index(t-1)||||||-0.119|0.295|
|||||||(0.701)|(0.683)|
|Transport Index(t-1)* Foreign||||||0.251*<br>(0.143)|-0.071<br>(0.172)|
|Tariffs(t-1)|0.000|0.000|-0.000|0.001|0.001|0.001|-0.000|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Input Tariffs(t-1)|0.000|-0.000|0.000|0.001|0.000|0.001|-0.001|
||(0.004)|(0.004)|(0.004)|(0.004)|(0.004)|(0.004)|(0.004)|
||0.015|0.022|0.017|0.022|0.021|0.023|0.019|
|Foreign|(0.016)|(0.016)|(0.016)|(0.016)|(0.016)|(0.017)|(0.017)|
|Observations|22,558|22,558|22,558|22,558|22,558|22,558|22,558|
|R-squared|0.029|0.029|0.030|0.027|0.028|0.027|0.031|
|Number of firms|3771|3771|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. All specifications include firm fixed effects. Robust standard errors, clustered at the industry-year level, are reported in parentheses. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 46
**Table 12:  Robustness Check on Autocorrelation. Ackerberg et al. TFP Measure**

|Banking Break 2001|2.859***<br>(0.686)|||||
|---|---|---|---|---|---|
|Rajan-Zingales Break 2001||0.412***<br>(0.061)||||
|Telecom Break 2002|||30.678***<br>(2.411)|||
|Insurance Break 2002||||15.203***<br>(2.219)||
|Transport Break 1997|||||-1.453***|
||||||(0.512)|
|Observations|6,142|6,142|6,059|6,059|5,440|
|R-squared|0.003|0.007|0.026|0.008|0.001|
|Number of firms|3771|3771|3771|3771|3771|

Notes: The dependent variable is the log TFP estimated using the Ackerberg et al. method for each of the 11 industries listed in Table 2. *** denotes significant at the 1 percent level, ** at the 5 percent level, * at the 10 percent level 47
# **[ON-LINE APPENDICES, NOT FOR PUBLICATION] Appendix A.  Recent History of Services Reform in India**

In collaboration with a team of local economists in India, we collected detailed information about policy changes affecting services sectors, in order to identify the key policy breaks for each sector. The local team consulted extensively with government and regulatory agencies, business associations, and sector specialists. These consultations were helpful to get an understanding of the relative importance of different policy changes, and to get a grasp of the degree to which reforms were actually implemented at a given point in time. One of the main angles from which we looked at services reform was the degree to which market forces were active in the sector, triggered by the possibility of new entry into the sector, both domestic and foreign. In some cases, legal or de-facto restrictions on entry were reduced, leading to actual entry of new providers, and in other cases market discipline increased due to a potential threat of new entry.

Our investigations took into account any major policy changes enacted between 1991 and 2003. In 1991, India embarked on a radical change of course in economic policy, involving deregulation and tariff reductions in many sectors. The initial reforms affected principally manufacturing sectors, while services were generally affected in the years following the first reforms. We record the first significant changes in financial services, telecommunications and transport as early as the 1993/94 fiscal year.<sup>25</sup> In what follows we highlight some of the major policy changes we recorded for 4 services sectors, and then describe our strategy for quantifying this information into a services reform index.

## **_Telecommunications_**

Initially, the sole provider of telecom services in India was the Department of Telecommunications (DoT), a government agency. Two large corporate entities were spun off from DoT in 1986, MTNL for Delhi and Mumbai, and VSNL for all international services.

The process of entry of private players in providing telecommunication services commenced in 1992 with several licenses issued to the private sector, for a switching capacity of over 1.5 million lines. The first privately-owned lines in operation were limited to private networks in industrial areas, which emerged during the fiscal year 1993/94.

In the 1994/95 fiscal year, cellular phone service emerged in India, with initially only consumers in major cities being able to choose between providers. All of these have a minority participation of foreign capital, which is restricted to 40 percent of equity.

During the same fiscal year, the government announced a new National Telecom Policy, which was the first official recognition of a move towards a privately operated telecommunications sector. The new policy provided the guidelines for further private sector engagement in Indian telecommunications. For fixed line services, the government decided to issue one additional license to provide basic telecom services in each state, additional to the local public incumbent provider. The licensing process for this begins but is not concluded in this fiscal year.

During 1995/96, the government attempted to auction additional licenses for both landline and cellular services, with some letters of intent issued to some operators for cellular operations. Rebidding had to take place for landline licenses in 13 states after the initial bids were considered low. Towards the end of that fiscal year, the telecom regulator (TRAI) was set up, to regulate further private engagement and settle disputes between operators.

> 25 We dated policy changes to the fiscal year rather than to the calendar year. The fiscal year in India starts on April 1 st and ends on March 31<sup>st</sup> .

48
In 1996/97, the government issued letters of intent for additional licenses in fixed services, and removed restrictions on cross-border borrowing for telecom projects. The following fiscal year saw the opening up of internet services for private providers, as well as the expansion of the definition of priority sector lending to include telecoms projects. This facilitated access to credit for telecom investments. In June 1998, the first private landline services became operational. By 1998, there was an effective choice of cellular services providers across most of the country.

During the 1999/00 fiscal year, the government issues a new telecommunications policy, which strengthened the regulating agency and outlined a further opening up of national long distance to private sector as well as the liberalization of international calls. Moreover, the licensing fee arrangements were shifted from a fixed license fee to revenue sharing for existing cellular and fixed line providers which reduced financing constraints of operators. The Department of Telecommunications was corporatized during the 2000/01 fiscal year.

During the 2002/03 fiscal year, the national long distance sector was opened to the private sector without any restriction on the number of operators. Despite an initial announcement of liberalizing the international segment in 2004, the government also terminated the VSNL monopoly in international services at the beginning if the 2002/03 fiscal year.

# **_Transport Services_**

Before the beginning of the reforms in the transport sector, the state played a dominant role in all segments. In air transport, there were two public monopoly carriers: Indian Airlines for domestic routes and Air India for international connections. Airport infrastructure was almost entirely operated by the National Airports Authority and the International Airports Authority, two public sector entities. In maritime transport services, the state controlled the major ports, and shipping services were controlled by both public and domestic private enterprises. The latter were tightly regulated by the state, and required official permissions for acquiring and selling a vessel. In the road transport sector, the public sector was the only provider of road infrastructure, and only nominal tolls were collected at a few bridges. Transport operations were subject to many rules and regulations related to the registration of different types of vehicles. Preferential access to credit for small trucking companies implied that these accounted for about 95 percent of the sector.

In 1990/91, citizens were allowed to apply for a license to operate air taxis, which was a way to circumvent to the domestic air transport monopoly to a limited degree. Air taxis faced a number of limitations, however. They were constrained to using small air craft and could not publish regular schedules. In maritime transport, regulation was changed in 1992/93 so as to allow foreign shipping lines to bring containers from the hinterland to a port and carry them to destinations abroad without trans-shipment en route. The acquisition and sale of vessels was no longer subject to government approval as of this fiscal year.

In 1993/94, entry into domestic air services was liberalized substantially with the official abolition of Indian Airlines‟ monopoly on domestic air services. This resulted in entry into domestic air services and competitive pressure in the domestic market. In maritime transport, freight and passengers fares which were previously set by the public sector were decontrolled to promote coastal shipping. In road transport, the National Highways Act was amended to enable levying of a fee on selected sections of national highways. This was an important step towards encouraging private engagement in road construction. In addition, most states abolished the “octroi” duty in 1993/94, which had previously acted as an internal tariff levied on the movement of goods across states.

In 1994/95, private participation was invited into the construction of container terminals, warehousing and storage facilities and for repairs and transportation within ports. In road transport, an amendment was passed to remove ceilings on the number of stage carriage permits that can be held by an individual or a company, thus facilitating the emergence of large trucking companies in a sector that was previously restricted to small enterprises. The 49
government also created the National Highways Authority (NHAI) in order to accelerate the pace of private sector participation in road building.

During 1995/96, operative restrictions on shipping companies were loosened. In particular, these were permitted to get their ships repaired at any shipyard without seeking prior approval from the government. In the following fiscal year, local equity requirements for companies owning a ship in India were abolished.

In 1997/98, foreign direct investment (FDI) in airlines was allowed up to a 40 percent ceiling, although foreign airlines were still barred from investing in the Indian air transport sector. Non-resident Indians were exempted from the FDI ceiling. In maritime transport, FDI up to 74 percent of equity was allowed in port construction and up to 51 percent in support activities such as pier operation. In road transport, 100 percent private engagement on a BOT (“Build, operate, transfer”) basis was permitted. Prior to this, the role of the private sector had been dismal, except as contractors to the government entities involved in infrastructure creation. For up to 74 percent of foreign participation in the construction, maintenance of roads and bridges, the investment approval was made automatic. In those cases where the collection of tolls was suspended due to political opposition, the government pledged to compensate investors according to international norms. The FDI ceiling in port construction was abolished entirely in 1998/99.

Starting in 1999/00, foreign equity participation in air infrastructure ventures was permitted up to 74 percent with automatic approvals and up to 100 percent with special permissions. Restructuring of some of the airports of the Airport Authority of India was envisaged to take place through long term leases to the private sector. In 2004, private airlines were allowed to operate international routes from India. Private airline Jet Airways has already gained a market share of 46 percent.

# **_Banking Services_**

In the initial situation before 1993, public sector banks controlled most of the Indian market for banking services, coexisting with a few international banks and private banks. The expansion of foreign banks, however, was limited by a host of explicit and non-explicit hurdles. Branch licensing policy required any bank to obtain a license before it could open a branch. The Ministry of Finance was responsible for the operations of public sector commercial banks and the RBI regulated all banks‟ activities. Interest rates of all types were determined by the government, and market forces were generally not active in this sector.

In the 1993/94 fiscal year, the government passed legislation to establish the in-principle approval of new private sector banks. The in-principle approval meant that the government was generally open to new entry with no explicit barriers, but potential entrants still had to go through various clearance processes. Approvals were not easy due to stringent RBI regulatory supervision. Equity holdings in new private banks up to 20 percent were explicitly allowed to “foreign institutional investors”, but foreign banks were barred from holding equity in a new private bank in India. Non-resident persons of Indian origin (termed NRIs) could hold equity of up to 40 percent. As far as operations are concerned, bank lending norms were liberalized and banks were given more freedom to allocate their inventories and receivables across different items. They were also allowed greater freedom in deploying their foreign exchange resources. Seven new private banks entered the market in this fiscal year.

The period between 1994 and 2000 saw only minor changes to banking regulations. A first cautious attempt of deregulating interest rates was made in 1994/95, but this only affected very large loans and hence a few corporate houses able to borrow such large amounts. The active interest rates on deposits over 2 years were freed in 1996/97. Moreover, the ceiling for housing loans to private individuals was raised in 1998/99, and a number of items were added to the definition of “priority sectors”, to which 40 percent of all lending was funneled by regulation.

50
In 2000/01, the government revised norms for entry of new banks in the private sector. While the government had signaled its general acceptance of private entry in 1994/95, this measure reduced the implicit barriers to entry. As of 2000, entry was made easier provided the entrant observed a continuous capital adequacy ratio of 10 percent from the date of start of operation and opened 25 percent of the branches in rural and semi urban areas. In addition, every bank was subject to allocating 40 percent of lending to priority sectors. In the same year, the government signaled its intention to eventually withdrawing from being a major player in the banking sector by reducing the minimum government equity share in nationalized banks to 33 percent and enabling the public sector banks to raise fresh equity from the capital.

In 2001/02, the government undertook a major step towards the deregulation of interest rates. Banks were allowed to lend at rates below the official “Prime Lending Rate” to exporters and other credit worthy borrowers (including public enterprises). Banks were allowed to set their own lending rates, and to undercut them when necessary. This marked the emergence of price competition for loans. Private sector banks have grown significantly more important as lenders by this time.

The restrictions to foreign engagement in the Indian banking sector were significantly reduced in 2002/03. The clearance process for foreign participation up to 49 percent in private banks was made automatic, rather than caseby-case as before. Beyond this ceiling for automatic clearance, foreigners could still apply for case-by-case permission. Foreigners could also acquire capital shares up to 20 percent in public sector banks, In the Union Budget for 2003/04, the limit of Foreign Direct Investment (FDI) in banking companies was raised from 49 percent to 74 percent. Aggregate foreign investment in a private bank from all sources allowed up to a maximum of 74 percent of the paid up capital of the bank. A full opening of the Indian banking sector to foreign capital, however, is yet to come.

# **_Insurance services_**

Reforms in the insurance sector commenced only in the second half of the 1990s. Prior to that, insurance was a public sector dominated sector. Life, general and medical insurance were all only conducted by four public sector entities under the control of the Ministry of Finance. A handful of very small domestic private sector insurers did exist. The level of competition was very low as each of the 4 large entities tended to specialize in one or two segments of the insurance market.

In 1998/99, the government announced its intention to open the Indian insurance industry to the private sector, including joint ventures between domestic and foreign providers. This announcement was implemented with the Insurance Regulatory Development Authority (IRDA) Bill passed in December 1999, which explicitly opened up the insurance sector to private providers, allowed foreign equity in domestic insurance companies subject to a maximum of 26 percent of capital. Potential new entrants would have substantial freedom with respect to pricing and management decisions, but would be subject to regulatory supervision. However, an entry permission was still required, and given the dominance of the public sector enterprises, significant acquisitions were more or less ruled out.

In 2000/01, the regulator passed 15 regulations regarding freedom of operations of private insurance companies as well as explicit disclosure norms. While this was important to define the rules of private entry, actual entry of private insurers did not take place before 2002. During the 2002/03 fiscal year, 12 new companies, among which life insurance and general insurance companies, were granted licenses and started business. In 2005, the government announced its intention to raise the FDI limit in the insurance sector from 26 percent to 49 percent.

51
# **Appendix B. The Construction of the Services Policy Reform Index**

In order to make the services policy information amenable to quantitative analysis, we translated the policy changes into a sector-specific reform index, taking values from 0 to 5.<sup>26</sup> Our primary concern was to maintain comparability across sectors, because our empirical strategy measures firms‟ exposure to upstream services reform by means of a weighted sum of the state of reform in four services sectors. Common definitions of what level of reform constitutes a given value of the index were used to preserve comparability. We started out with a general template of degrees of openness that is not specific to any sector, and then adapted this template to the specificities of each of the four services sectors.

In our general template, we attach an index value of 0 to a situation where hardly any progress has been made and the public sector is either the only relevant provider of services or has an extremely strong grip on private providers. A level of 1 indicates at least some scope for private sector participation and some liberalization of operational decisions, combined with some very limited scope for foreign participation (limited, for example, by low FDI ceilings or announced only as intentions). In order to qualify for an index value of 2, we required that there be only a limited degree of interference with operational decisions by public authorities, a substantial price liberalization, and clear scope for foreign participation even if only in narrowly defined segments and as minority participations. Still, the state remains a dominant actor in the sector. An index of 3 implies significant scope for private providers, including foreign ones, a noticeable competitive pressure on the public incumbents from new entrants, and explicit possibilities for foreign equity participation. A level of 4 is equivalent to little public intervention into the freedom of operation of private providers, the possibility of majority foreign ownership, and the dominance of private sector entities. Finally, a level of 5 would be equal treatment of foreign and domestic providers, a full convergence of regulation with international standards and unrestricted entry into the sector.

In adapting the template to sectors, one needs to take into account that in some sectors liberalization can proceed at different paces in different segments. In telecommunications, for example, developing countries are typically quicker to allow private (and foreign) capital into cellular services than into landlines. In segments where private entry is possible, operators tend to face relatively little public intervention in the operation of their business. As a result, one is likely to observe a coexistence of segments in which market forces can govern more freely with others that remain a public monopoly. In other sectors such as banking, there is no such natural division into segments. Instead, one might find a situation in which private (and foreign) entry has taken place into the provision of almost all banking products, but significant public interference with private decisions remains in the form of directed lending to priority sectors or interest rate restrictions. Hence the need to rephrase the index definitions for different sectors while trying to maintain the same sense of “average” openness associated to a given level of the services reform index. In what follows we present the sector-specific definitions of the index, and juxtapose these with the actual reform events that determined progress to the next level of the index. To illustrate India‟s reform progress in the services sectors we analyze in this paper, Figure 1 gives a graphical illustration of the variation contained in the services reform index.

> 26 The European Bank for Reconstruction and Development produces a similar set of indices for transition countries in their 2004 Transition Reform, and some of the definitions used in that index have inspired the construction of our index.

52
<!-- Start of picture text --> i<br>4<br>3 +<br>/ ! /<br>Telecom / { ;<br>:f /. f Transport<br>1 OO: Banking - $e7 —4H Insurance<br>/<br>/<br>/<br>/<br>/<br>0<br>1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004<br><!-- End of picture text -->
# Telecommunications

|De|finition of step|Year of<br>reformpr|achievement in India, and accomplishments indicating<br>ogress|
|---|---|---|---|
|0|Clear public sector dominance with no private<br>sector involvement<br>At most announcement of future private sector role<br>strong<br>political<br>interference<br>in<br>management<br>decisions<br>low tariffs and extensive cross-subsidies|||
|1|Some first instances of private sector involvement,<br>but limited to particular segments of the market.<br>Some liberalization of operational decisions where<br>private sector is involved.<br>At most there is talk about allowing foreign<br>presence,but notyet in operation.|1993/94|The first private networks in industrial areas were<br>licensed and put in operation. Licensing process for<br>cellular service begins, envisaging the possibility for<br>foreign participation.|
|2|Private participation begins in important segments<br>of the market, most likely the cellular segment<br>(which tends to be the first to rely on private<br>participation).<br>In<br>these<br>segments,<br>public<br>interference with operational decisions is limited.<br>There<br>is<br>clearly<br>defined<br>scope<br>for<br>foreign<br>participation, but with certain limits.<br>In other segments, the public sector remains<br>dominant,with fixed-line tariffs stillpoliticallyset.|1994/95|Private cellular service providers emerge in major cities,<br>all of which have some foreign equity. Process of issuing<br>further licenses to private sector begins. New Telecom<br>Policy announced to define framework for further<br>private sector participation.<br>FDI possible up to 49 percent.|
|3|Significant scope for private providers, including<br>foreign ones, beyond one segment of the market.<br>Some competitive pressure on pre-reform fixed line<br>incumbent.<br>Explicit<br>possibilities<br>for<br>foreign<br>equity<br>participation.|1999/00|New Telecom Policy issued which defines the way ahead<br>for a complete opening of national and international<br>long distance market. Regulator strengthened, licensing<br>fee arrangement made more favorable for private<br>operators.|
|4|Hardly any public intervention in cellular and<br>value added services, where the private sector is<br>dominant<br>and<br>foreign<br>investors<br>significantly<br>present. Free entry into relevant segments of the<br>fixed line market. Comprehensive regulatory and<br>institutional reforms.|2002/03|National long distance market fully open with no<br>restrictions on the number of operators. Public<br>monopoly in international gateways abolished.|
|5|Private sector providers dominate in almost all<br>segments. Effective regulation through independent<br>regulator including a coherent framework to deal<br>with<br>interconnection<br>and<br>licensing.<br>Effective<br>competition in most segments of the market with<br>unrestricted entry.|-||

54
# Transport

|De|finition of step|Year of<br>reformpr|achievement in India, and accomplishments indicating<br>ogress|
|---|---|---|---|
|0|Little progress, public sector is the sole provider of<br>all infrastructure, and has dominant stakes in<br>several segments of the transport sector. Where the<br>public sector is not an operator such as in road<br>transport,it regulates operations heavily.|||
|1|Increased scope for private sector participation in<br>some segments of the sector.<br>Some liberalization of operational decisions<br>Some limited scope for foreign participation in serv<br>provision<br>At most there is talk about allowing foreign<br>presence,but notyet in operation.|1993/94|Abolition of the formal monopoly in domestic air<br>services, entry into domestic air services. Liberalization<br>of prices in maritime freight and passenger transport.<br>Explicit recognition of the possibility to levy user fees<br>on national highways, which was considered a<br>precondition for private engagement.|
|2|Private participation begins in important segments<br>of<br>the<br>market.<br>In<br>these<br>segments,<br>public<br>interference with operational decisions is limited.<br>There<br>is<br>clearly<br>defined<br>scope<br>for<br>foreign<br>participation, but with certain limits. In other<br>segments,the state remains the dominant actor.|1997/98|FDI in air transport up to 40 percent is allowed<br>(although foreign airlines are excluded). Majority FDI<br>possible in the construction and operation of ports. First<br>private sector engagement in road infrastructure under<br>the “Build, Operate, Transfer” scheme.|
|3|Significant scope for private providers, including<br>foreign ones, beyond one segment of the market.<br>Some competitive pressure on public sector<br>operators.<br>Explicit<br>possibilities<br>for<br>foreign<br>equity<br>participation.|2004/05|Private airlines permitted to serve international routes.<br>Both public sector airlines feel significant competitive<br>pressure from private competitors.|
|4|Important segments are almost free of public<br>intervention, with private sector operators being<br>dominant and significant foreign engagement<br>present. Free entry into relevant segments of the<br>transport market.|-||
|5|Private sector providers dominate in almost all<br>segments. Effective competition in most segments<br>of the market with unrestricted entry. Equal<br>treatment of foreign and domesticproviders.|-||

55
# Banking

|De|finition of step|Year of<br>reformpr|achievement in India, and accomplishments indicating<br>ogress|
|---|---|---|---|
|0|Little progress, public sector plays the dominant<br>role. Where there are private operators, their<br>operations and scope of services on offer are tightly<br>regulated.|||
|1|Increased scope for private sector participation.<br>Some liberalization of operational decisions, but<br>directed lending remains prevalent. Some limited<br>scope for foreign participation in domestic banks.|1993/94|Legislation passed to signal government’s in-principle<br>approval of new private entry into banking sector. 7<br>new banks enter the market. FDI up to 20 percent but<br>foreign banks are barred. Banks given more freedom to<br>allocate their inventories and receivables across different<br>items.|
|2|Significant private participation becomes possible.<br>Public interference with operational decisions and<br>discretionary barriers to entry are limited. There is<br>clearly defined scope for foreign participation, but<br>with certain limits. The state remains a dominant<br>actor.|2000/01|Discretionary barriers to entry into banking sector are<br>lowered significantly. State signals its intent to<br>eventually withdraw from the banking sector.|
|3|Significant scope for private banks, including<br>explicit<br>possibilities<br>for<br>foreign<br>equity<br>participation. Some competitive pressure on public<br>sector operators.|2001/02|Major interest rate deregulation allows banks to set<br>prices more freely. Private sector banks gain more<br>relevance as lenders and begin to crowd out public<br>sector banks in some instances.|
|4|Important segments are almost free of public<br>intervention, with private sector operators being<br>dominant and significant foreign engagement<br>present. Free entry into relevant segments of the<br>transport market. Majority foreign ownership is<br>possible.|2002/03|Foreign participation in Indian banks is made<br>significantly easier. Clearance for up to 49 percent of<br>equity is automatic, and majority ownership is possible<br>subject to case-wise approval.|
|5|Private sector providers dominate in almost all<br>segments. Effective competition in most segments<br>of the market with unrestricted entry. Equal<br>treatment of foreign and domestic providers. Full<br>convergence<br>of<br>regulation<br>with<br>international<br>standards.|-||

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# Insurance

|De|finition of step|Year of<br>reformpr|achievement in India, and accomplishments indicating<br>ogress|
|---|---|---|---|
|0|Little progress, public sector plays the dominant<br>role.|||
|1|Increased scope for private sector participation.<br>Some liberalization of operational decisions, but<br>still massive intervention. Some limited scope for<br>foreign participation but low FDI ceilings.|1999/00|Bill passed to open up the insurance sector to private<br>entry, including foreign equity participation up to 26<br>percent. Substantial freedom with respect to pricing, but<br>strict<br>regulatory<br>supervision.<br>Discretionary<br>entry<br>permission was required, and no acquisitions possible<br>due topublic sector dominance.|
|2|Significant private participation becomes possible.<br>Public interference with operational decisions and<br>discretionary barriers to entry are limited. There is<br>clearly defined scope for foreign participation, but<br>with certain limits. The state remains a dominant<br>actor.|-||
|3|Significant scope for private banks, including<br>explicit<br>possibilities<br>for<br>foreign<br>equity<br>participation. Some competitive pressure on public<br>sector operators.|2002/03|Entry of 12 new private providers of insurance services,<br>which constitutes a massive shake-up of the market.<br>Competitive pressure on incumbent public insurers. FDI<br>ceilingremains at 26percent.|
|4|Most operational decisions are almost free of public<br>intervention, with private sector operators being<br>dominant and significant foreign engagement<br>present. Free entry into relevant segments of the<br>market. Majorityforeign ownershipispossible.|-||
|5|Private<br>sector<br>providers<br>dominate.<br>Effective<br>competition in most segments of the market with<br>unrestricted entry. Equal treatment of foreign and<br>domestic providers. Wide array of insurance<br>services available at competitive prices. Full<br>convergence<br>of<br>regulation<br>with<br>international<br>standards.|-||

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