Status of Indian Economic Reforms: A Hiatus or a Pause Before Acceleration?

Status of Indian Economic Reforms:  A Hiatus or a Pause Before Acceleration?

T.N. Srinivasan*

1.      Introduction

            The Indian Economy has grown at an average rate of 6% per year during the 19 year period (1993-94 to 2002-03) after the current prime minister, Dr. Manmohan Singh initiated systemic economic reforms in 1991.  In fact, a break from the infamous “Hindu rate” of growth averaging 3.75% per year of the three decades 1950-80 of state-controlled, state-dominated and inward-oriented development strategy occurred in the 1980’s, with an average growth of 5.9% per year during 1980-90 following some hesitant and piece-meal liberalization of the economy.  However, the eighties also marked a departure from the macroeconomic stability of the graveyard that characterized the previous three decades that made growth acceleration unsustainable.  Soaring fiscal deficits (rising from 6.34% of GDP in 1981-82 to 9.4% in 1990-91), tripling of external debt (from $23 billion in 1983-84 to $69 billion in 1990-91) of which high cost debt to private creditors grew five fold ($4 billion to $21 billion during the same period), depletion of external reserves to just $0.47 billion, less than two weeks worth of imports, by June 1991, rising inflation, which peaked at 15% a year in August 1991, were all harbingers of an impending macro-economic/balance-of-payments crisis.  The crisis, which came about as the first gulf war broke out and oil prices rose significantly and external creditors (particularly non-resident Indians) withdrew their funding. India had to seek the help of the International Monetary Fund (IMF) and the World Bank to tide over the crisis.

            The IMF and the World Bank, to no one’s surprise, conditioned their assistance to implementation of economic reforms.  In an earlier macroeconomic crisis in 1966, India sought and got assistance from the same two Institutions, again conditioned on reforms including devaluation of the rupee and liberalization of external sector policies.  The liberalization that ensued did not last long, was reversed in 1968 and economic controls intensified thereafter.  The fact that after the 1991 crisis, the reforms initiated were systemic, going beyond the external sector, and have not been reversed since, is in my view due to two factors, both external.  One was the collapse in 1991 of the Soviet Union, the model for India’s economic planning, supplier of military hardware and supporter of India’s interests in the United Nations Security Council.  The second, perhaps more important, was the spectacular growth of China since its emergence from economic insulation, courting foreign investment and adoption of market oriented economic management (Table 1).  The fear of being left behind by China, which had caught up with India’s level of real income per capita only in the early 80’s and with whom India had fought and lost a border war in 1962 must have weighed on the minds of policy makers and led them to their realization that minor tinkering and relaxation of a control here or there that was proving to be irksome, as India has been wont to do, would no longer suffice and major systemic reforms of the economy was called for.

            The process of reforms, initiated in mid-1991 and carried forward ever since at varying speed, extent and depth, included, first of all the elimination of some of the most intrusive state controls on the economy such as investment and import licensing, and control over capital issues.  Efforts to contain the fiscal deficits were undertaken and were initially successful, but later slackened.  Tariff rates on imports were reduced substantially over a period of time from absurdly high import-weighted average rate of 87% for all goods (and an even higher 164% on imports of consumer goods) in 1990-91 before reforms, to an average of 30% in 1999-2000 and to 28% in 2004.  Market forces were allowed to play a role in the determination of the exchange rate of the rupee.  Although formally floating, it is, in fact managed by the Reserve Bank of India and has been moving within a narrow range.  Financial repression of the pre-reform era, with controls on interest rates, selective credit controls and the commandeering of over 60% of the loanable funds of the nationalized bank system through cash and liquidity reserve rates has been largely eliminated.  Interest rates are market-determined by and large, though banks are still required to lend a certain proportion of their loan portfolio to priority sectors. Reforms of the capital market included the establishment of a National Stock Exchange, broadening the market for government securities and the introduction of new financial products.  Foreign direct investment and portfolio investment are allowed with far fewer impediments as compared to the pre-reform era. Disinvestment  of equity in public enterprises (privatization in the sense of outright sale of a public enterprise to private investors has been rare) has taken place.  Entry of private players in what used to be state monopolies such as in telecommunications was allowed and regulatory agencies were established to govern their entry and performance.  However crucial infrastructural enterprises such as railways, electricity generation, distribution and transmission, major ports and airports are entirely or largely in the public sector.  Governments at all levels are heavily involved in the provision of social services such as education and health and also in the supply of water for irrigation.

            The systemic reforms initiated by Dr. Manmohan Singh as Finance Minister, have put India in an enviable position it occupies today among developing nations, and indeed, in some ways, among all nations.  By the same token, without completing, widening, deepening and accelerating the process of reforms, India will not be where it ought to be in the future, that is, as one of economically developed nations, without anyone in the nation in absolute poverty, with a hard currency that other nations would choose to include in their reserves, and admired as an innovating nation and a thriving participatory democracy.  Unfortunately, the process seems to be in a hiatus presently as I will argue in the next section.  Hopefully this is a temporary pause prior to acceleration.

2.      Post Reform Economic Performance

            GDP Growth

The Indian economy in the autumn of 2005 is vastly different from what it was prior to reforms.  Table 2 depicts real GDP growth.  After falling to a low of 1.3% in the crisis year of 1991-92, real GDP growth rate accelerated and reached a peak of 7.8% in 1996-97.  Since then, it has been fluctuating, reaching a low of 4% in 2002-03 when the economy was hit by a severe drought.  In part aided by the recovery from the drought following a normal monsoon, growth rate increased to 8.5% in 2003-04.  Rate of growth for the current fiscal year (2005-06) is projected to be between 7% and 7.5%.  IMF (2005a, 2005b) disentangles the role of cyclical (e.g., monsoons) and structural factors in GDP growth.  Once the fluctuations in GDP growth due to rainfall fluctuations are taken into account, it turned out that the “rain-adjusted GDP growth averaged 4.3% in 2003-04, well below the headline growth of 8.2 percent and its recent five-year average of 5 percent.  However the rainfall-adjusted series suggest that underlying growth in 2002-03 was in fact quite robust, despite the drought” (IMF 2005b, p. 5).  The analysis of growth suggests that “. . . the evidence that trend growth accelerated in 1992 [that is the year after the initiation of systemic reforms] is quite robust to whether growth is measured using real GDP or rain-adjusted real GDP.  While trend growth averaged 5.8 percent between 1992 and 2000, trend growth in more recent years has fallen to an average level of five percent” (IMF 2005b, p. 6).  This finding, taken together with the fact that the Planning Commission, in its recent mid-term appraisal of the Tenth Plan (2002-2007), has acknowledged that the plan target of average annual growth of 8% cannot be realized and that actual growth is likely to fall significantly below is disturbing confirmation (Hindu 2005b), if indeed one was needed, that the momentum of growth achieved in the initial post-reform years, when growth rate peaked at 7.8% in 1996-97, is yet to be regained.

      The sectoral composition of GDP is not comforting either.  Even after five and a half decades of planning for industrialization, the share of industry (manufacturing) in GDP at factor cost was only 21.9% (9.2%) in 2004-05, (RBI, 2005a, Table 1).  In contrast, World Bank (2005, Table 4-2) reports industry (manufacturing) share in China’s GDP was 52% (39%) compared to India’s 27% (16%) in 2003.  Growth of agriculture, on which more than 60% of India’s population still depend for their main source of income, has been anemic, at less than 2.0 per year on average since 1992-93.  The rate of growth of industry (manufacturing ) at 8.3% (9.2%) in 2004-05 was higher than its level at 6.5% (6.9%) in 2003-04 ( RBI, 2005a, Table 1).  In the first quarter of 2005-06 it further increased to 10.1% (11.3%).  It is too soon to tell whether industrial (manufacturing) growth is moving towards a higher trajectory.

            Poverty Reduction

Although the acceleration of growth in 1980’s though unsustainable, being debt-led and based on fiscal profligacy as it was, it nonetheless had a favorable impact on poverty (Table 3).  Post reform growth though not markedly faster than that of the 1980’s continued to contribute to poverty reduction.  Thus after fluctuating for nearly three decades around more than half of the total population, poverty ratio declined in the two and a half decades of rapid growth and was estimated at 26.1% in 1999-2000.  The Tenth Five Year Plan, with its original target of an average rate of growth of 8% per year in GDP had targeted a fall in the poverty ratio to 19.3% by 2006-07.  As noted earlier, the growth target will not be achieved and it is unlikely the contemplated reduction in the poverty ratio will be attained either.  Even if it had been attained, the achievement would have been modest; poverty, as measured by the proportion of the population being below a very modest poverty line would still be 19.1% and not zero.  More than 200 million people would still be poor. 

            Fiscal Performance

      The most conspicuous failure of the post reform era is undoubtedly in the failure to restore fiscal balance (Table 4).  The consolidated fiscal deficit of the central and state governments was 9.4% of GDP in 1990-91 as the economy was in crisis.  The efforts of fiscal consolidation slackened (after reducing the deficit by a third to 6.5% in 1996-97), and the overall fiscal deficit ballooned (particularly at the state level) to reach about 10.1%  in 2003-04.  The budget estimates for 2004-05 proposed reducing it to 7.9%.  The revised estimates for the year show that there was a slippage of 0.4%.  Instead of the drastic reduction proposed in the budget of 2004-05 at the state level, from 4.4% in 2003-04 to 3.6%,  the revised estimate is 3.8%, still creditable reduction.  Even if the budgeted value of 7.7% for the consolidated deficit in 2005-06 is realized, it still would be too high.  Some have suggested that the public deficit has crowded out non-household (i.e., corporate) private investment.  This argument is not persuasive for several reasons, including the fact that interest rates have not gone up and the commercial banks are holding more government paper than they are required to do for prudential reasons, rather than lend to the private sector.  It is more plausible to suggest that the private sector’s investment schedule had shifted to the left since 1996-97 because of a poor investment climate.

      The Finance Minister, in his budget speech (GOI 2005), admitted to a considerable strain in making the budget for 2005-06 consequent to accepting the recommendations of the Twelfth Finance Commission which added about 0.75% of GDP to the expenditure side of the central budget.  The Fiscal Responsibility and Management (FRBM) Act of 2003 had mandated the central government to eliminate the central government’s revenue deficit by March 2008 and to reduce fiscal deficit to 3% of GDP by March 2007.  The Act was later amended to shift these dates to March 2009 and 2008, respectively.  The rules under the Act required annual reductions by 0.5% and 0.3% on revenue and fiscal deficits respectively at the end of each financial year, starting with 2004-05 (MOF 2005a, Box 2.7).  The revised estimates of the two deficits for 2004-05 were respectively 2.7% and 4.5% as compared to 3.6% and 4.8% in 2003-04.  While claiming the achievement of required fiscal correction in 2004-05, the Finance Minister said that he “was left with no option but to press the ‘pause’ button vis-à-vis FRBM Act” (GOI 2005, p. 23), largely because, in his view, accepting the recommendations of the Twelfth Finance Commission drastically changed the pattern of devolution and spending.

      Unfortunately, attributing the additional expenditures arising from the acceptance of the recommendations of the Twelfth Finance Commission as the reason for pressing the “pause” button is not convincing.  After all, the Finance Commission is a constitutional body that is appointed every five years, and the record of recommendations of the previous eleven commissions were known when the FRBM Act was passed.  It is hard to believe that the Act formulated its targets without anticipating and taking into account the possible impact of recommendations of the Commission and their impact.  It is just as hard to believe that the Planning Commission formulated its growth targets for the Tenth Plan without adequately analyzing the feasibility of achieving the targets, in particular, not allowing for the virtual certainty of rainfall fluctuations, and then scaling them down as it did recently when faced with reality.

      The National Common Minimum Programmed (NCMP 2004) had pledged that “all subsidies will be targeted sharply at the poor and the truly needy, like small and marginal farmers, farm labor and urban poor.  A detailed road map for accomplishing this will be unveiled in Parliament within 90 days.”  No such road map was unveiled within the stipulated 90 days after the assumption of office by the United Progressive Alliance (UPA) government in May 2004.  Instead, the Finance Minister asked the National Institute for Public Finance and Policy (NIPFP) to prepare a report and promised to place it in Parliament in its winter session in 2004.  NIPFP’s report was published in December 2004 (MOF 2004a).  It suggested a three-tier (Merit I, Merit II and Non-Merit) hierarchy of the government’s social and economic services.[1]  In its view, “while merit goods deserve subsidization in varying degrees, Merit I dominates Merit II in terms of desirability of subsidization.  Furthermore, the case for subsidizing non-merit goods becomes a tenuous one” (MOF 2004a, p. 2).  Yet, non-merit subsidies accounted for 58% of the total subsidies in 2003-04!  There has been very little change in 1987-88 when subsidies accounted for 4.53% of GDP and in 2003-04 the percentage was 4.18 (MOF 2004a, Table 2.4).  Explicit subsidies at 1.7% of GDP accounted for 40% of total subsidies.  If this share remained the same in the subsequent two years based on data on explicit subsidies in the 2005-06 budget document, total subsidies would account for 3.8% of GDP in 2004-05 and are budgeted at 3.4% of GDP in 2005-06, representing a modest, but welcome, reduction compared to 2003-04.

      The NIPFP report makes several recommendations on addressing the subsidy problem.  Unfortunately, given the strong opposition of the left parties in the UPA, to any subsidy reduction not much by way of concrete action is likely.  The Finance Minister admitted as much in his budget speech.  After saying that the three main products that involve large explicit subsidies from the budget and otherwise were food, fertilizer and petroleum, he added, “However, we must now take up the task of restructuring the subsidy regime in a cautious manner and after a thorough discussion” (GOI 2005, p. 22), as if there had been no such discussion!  In fact, there are various proposals, including those in the NIPFP report and others, for addressing the food and fertilizer subsidies without adversely affecting rural and urban poor, including small and marginal farmers.  The NIPFP report covered only central government subsidies.  The subsidies from the state government, particularly on electricity, are substantial.  A comprehensive social cost-benefit analysis for explicit and implicit subsidies by governments at all levels most likely will show that the benefit/cost ratio to be low.  In any case, it is clear that not much progress has been made to address the drain on the public exchequer from subsidies. 

      On the revenue side, Table 1, central tax revenue (gross of states share as a proportion of GDP was 10.1% in 1990-91.  Since 1999-00 it has fluctuated around 9%.  It  is budgeted at 10.5% in 2005-06, (Rao, 2005, Table A5).  Total tax revenue of central and states together as a proportion of GDP has been fluctuating between 15% and 16% of GDP (MOF, 2005a, Table 2.11, Rao, 2005, Table A.6).  This average tax intake in India is low by international standards, although marginal rates are high (IMF 2005b, p. 33).  The Indian tax system continues to depend highly on indirect taxes, although central direct tax (personal and corporate) revenues have risen substantially from 1.9% of GDP in 1990-91 to 5.0% in the budget estimates for 2005-06 (Rao 2005, Table A5).  However, the states to whom jurisdiction of taxation of agricultural incomes and wealth has been assigned in the constitution have left them largely out of the tax net.  Other direct taxes at the state level do not amount to much.

      In his analysis of thirty years of tax reform in India, Acharya (2005) points out:

In the mid-1970s, by the standards of modern tax theory and practice, India’s tax system was a mess.  Direct taxes were levied at confiscatory rates, which encouraged rampant evasion.  Indirect taxes on domestic and foreign trade boasted innumerable commodity-specific rates and hundreds of end-use exemptions and preferences, which made a mockery of the public finance canons of simplicity, economic efficiency and equity.  By the year 2005 the tax structure, especially at the central government level, had been substantially reformed.  Although the system is still far from perfect, serious progress has clearly been made in the intervening three decades.

He rightly concludes his analysis by saying that the work of tax reform is never finished and offering a few suggestions for future reforms.  He is absolutely right that import duties are still high, at an average of 20%, making India one of the most protected economies of the world, and have to be brought down to a uniform level of 10%.  Excise duty reforms in his view include administrative reforms, review of the large number of exemptions, and resurrecting the role of special additional duties on luxury products.  A major step of reform on the state level of replacing the cascading system of sales taxes by a value added tax (VAT) has been introduced in 19 states and two union territories in April 2005, against opposition from traders  The non-participating nine states include some major ones.  Participating states levy VAT at different rates thereby creating distortions in the location of economic activity and opportunities for tax arbitrage.  The preparation for a successful functioning of VAT, including devising an interconnected accounting system, was not made.  Acharya views the integration of central VAT/services tax structure with state VAT as the biggest challenge to future tax reform.  That said, as IMF (2005b, p. 46) notes “tax reform combining lower statutory rates with base broadening is likely to enhance growth prospects.”  The proposals in the report of the task force on the implementation of FRBM Act (MOF 2004b), if “implemented as a package would imply a significant increase in tax productivity” (IMF 2005b, p. 46).

India’s public debt at 81.4% of GDP in 2003 is a serious problem, even though less than a tenth of it at 7.2% of GDP is foreign currency denominated (IMF 2005a, Table 8).  This debt figure does not include implicit or contingent liabilities or cost of recapitalization of any public sector banks if their capital adequacy falls or fails to meet required norms.  Projections of alternative scenarios (IMF 2005a, Box 2) suggest that in a base-line some-reform scenario, with growth averaging 6.25%, with reforms implemented at a more modest pace than proposed in (MOF 2004b), debt/GDP ratio stabilizes at around 82.75%.  On the other hand, this scenario is very vulnerable to shocks—a fall in growth rate by two standard deviations for two years increases debt by 14.5% by 2009-10, which does not stabilize even after the shock subsides.  On the other hand, in an alternative high reform scenario, debt/GDP ratio declines to 75%. The study of Roubini and Hemming (2004), suggests that compared to other countries with similar Moody’s long-term local currency credit ratings, India’s position is worse in terms of measures such as fiscal deficit, ratio of government debt to GDP, and ratio of debt to government revenue. Using countries that have experienced financial crises as an alternative comparison group, the two authors note that India typically stands worse on measures such as fiscal deficit, primary deficit, debt to GDP ratio, interest to revenue ratio, and government debt share in bank assets. Finally, the authors suggest that India’s external vulnerability can be seen from its low level of net foreign assets.  As of March 31, 2004, India’s total foreign assets amounted to $169 billion (of which foreign currency reserves were $142 billion) against which liabilities totaled $210 billion (of which external debt was $113 billion) leaving net liabilities of $41 billion (MOF, 2005b).

            Domestic Savings and Investment

      Table 5 shows that the rate of gross domestic savings reached a peak of 28.1% of GDP in 2003-04, and most of it consisted of household savings.  A welcome feature is the decline in the dissaving of public sector from 2.7% of GDP in 2001-02 to 0.3% in 2003-04.  Corporate saving has remained around 4% of GDP.  The fact that more than a half of household savings (strictly speaking, it includes savings of unincorporated enterprises also) consisted of direct savings in the form of physical assets  (that is, saving and investment were the same decisions with no financial intermediation involved), and this proportion, has continued to exceed the proportion of savings in financial assets, is puzzling.  Apparently, the availability of a broad range of financial products after financial sector reforms, including mortgage financing of housing, has failed to have much of an effect on the composition of household savings.  There is no statistical information on the risk-adjusted rates of return on household savings (and investment) in physical assets.  If they are lower than risk-adjusted returns that the same resources would have earned had they been saved in the form of financial savings, available through intermediation for financing investment elsewhere in the economy, obviously the allocation of household savings between financial and physical assets is inefficient.[2]

      It is seen from Table 5 that the current account turned from being in deficit, as would be normal for India as a developing country, into surplus in 2001-02.  This means that gross domestic capital formation was less than gross domestic savings to the extent of the net capital outflow corresponding to the surplus.  With the recent spike in crude oil prices, the merchandise deficit more than doubled from $15.4 billion in 2003-04 to $38 billion in 2004-05.  In the first quarter of 2005-06 it was $15.8 billion, more than thrice its level in the first quarter of 2003-04.  Although the surplus in invisibles trade also rose from $26 billion to $31.7 billion during the same period, the current account turned into a deficit of $6.4 billion in 2004-05 compared to a surplus of $10.6 billion in 2003-04. The deficit was $6.2 billion in the first quarter of 2005-06 (RBI, 2005b, Table 43, p.5894-895.  In any case, for a developing economy such as India to have invested part of its savings abroad as it did for three years in a row from 2001-02 is not only unusual but unhealthy..

            External Sector

      2.5.1 Exports of Goods and Services

            In US dollar value terms, India’s exports grew by 7.7% per year on an average during 1990-2000.  Since then, growth rates nearly tripled to around 21%, except in 2001-02 when recession in the US and other major markets resulted in a small decline by 1.6% (MOF 2005a, Table 6.4).  However, China’s exports grew even faster at 12.4% per year during 1995-2001 compared to India’s 7.3% during 1995-2000, and has grown at nearly 35% in 2003 and 2004 (MOF 2005a, Table 6.5).  Table 6 shows that India’s share of world merchandise exports rose to 0.8% in 2004 from a low of 0.5% in 1983, while China’s share more than quintupled from 1.2% to 6.5% during the same period.  China was the third largest merchandise exporter in the world in 2004, while India was a distant 30^th.  In global trade in commercial services, including information technology-enables services (ITES), India did relatively better with a share of 1.9% and a rank of 16 in 2004, compared to China’s 2.9% and ninth rank (WTO 2005, Tables I.5, I.7 and II.2).  Both China and India are expected to gain a significant share of the global market of textiles and apparel with the expiry of the infamous Multifibre Arrangement.  Apparel imports from China are already being targeted for restrictions by the US and the EU, and China itself has announced that it will levy a tax on textile exports so as to placate the US and EU.  Similar action against Indian exports are possible, although India as a founder member of the WTO is not subject to the provisions of China’s Agreement of Accession to the WTO that have been used in restricting China’s exports.

      2.5.2  Service Exports and BPO        

AIMA (2003) projects that by 2020, India can hope to generate $139-$365 billion of additional revenue from the supply of remote services for foreign residents and in situ services for visitors, pushing up the GDP growth rate by an additional 0.6%-1.5% per year between 2002-20.  It estimates the direct and indirect employment generated by this additional growth to be between 20 and 72 million.  To put these numbers in perspective, India is targeting a GDP growth of at least 8% per year in the next two decades.  Its labor force, estimated at 363 million persons in 1999-2000 (MOF 2004c, Table 10.7), is expected to grow at 1.5% per year in the next two decades.  This means that 125 million persons would be added to the labor force during the period.  IT job growth projected in AIMA (2003) could provide jobs for a significant share of these additions to labor force, assuming that each IT worker is fully employed. 

The methodology of projection by the task force of (AIMA 2003) is not transparent.  The possibility that the projections of revenues and employment are very optimistic cannot be ruled out.  However, for the very near term, official projections are also available (MOF 2005a, Box 6.2).  The Ministry of Finance expects the IT sector (including ITES) to grow to 7% of GDP by 2008 from around 2.64% in 2003-04.  This compares very favorably with a share of 8.9% only for manufacturing and 21.9% for industry in 2004-05 (RBI, 2005a, Table 1).  Exports of this sector have grown rapidly and are expected to be between $57-65 billion, accounting for 35% of total exports in 2009, a rise of 14% from 2003-04.  ITES/BPO exports rose from $0.57 billion in 1999-2000 to $3.6 billion in 2003-04 and are expected to rise to $21-24 billion by 2008.  Exports of software services nearly doubled in a short span of two years, from $9.6 billion in 2002-03 to $17.3 billion in 2004-05 (RBI, 2005b, Table 43, p.5894-5).  The fact that India’s share in world IT spending was only 3.4% in 2003-04 suggests that there is still a considerable potential for significant further growth.  The IT sector will play an important role in India’s future growth prospects (Srinivasan 2005a).  Once the IT diffuses and gets adopted in most of the economy, one can expect total factor productivity to grow faster thus raising GDP growth.

Service imports from and BPO to India have attracted and continue to attract media attention in the United States (e.g. the columns of Thomas Friedman in the New York Times and his widely reviewed new book, The World is Flat.)  It has also evoked a protectionist response:  “… state legislators have introduced at least 112 bills in 40 states to restrict outsourcing till March 14 this year. . . . The New Jersey bill, which awaits the governor’s decision to sign or veto would be the most far-reaching anti-outsourcing measure in the country by prohibiting all state contract work from being performed overseas[3]” (Mozumdar 2005).  All this is indicative of the fact that not only within India but also in the rest of the world, the expectations are that India will be a major player in the IT industry in general and BPO in particular.  There is an emerging consensus that India will continue to grow rapidly in the next several decades, and that its IT sector broadly speaking will contribute significantly not only to GDP growth but also to employment generation and poverty alleviation.

2.5.3        Foreign Direct Investment

            In contrast to the spectacular growth of exports of software and ITE services, including BPO, India’s record of attracting foreign direct investment is abysmal (Table 7).  However, India has attracted significant amounts of portfolio investment, $28.2 billion gross, and $11.4 billion in 2003-04 and $40.5  billion gross and $11.7 billion net in 2004-05 (RBI, 2005b, Table 43, pp.5894-5).  This type of foreign investment is volatile as is seen from outflows of such investment.  In its peak in 2001-02, FDI inflows amounted to $6.7 billion and in the most recent year 2004-05, the inflows are $5 billion (MOF, 2005a, Table 6.2 and RBI, 2005b, Table 46).  India continues to lag behind China, Hong Kong, and Singapore (and Thailand until 2001) in FDI inflows.  Differences in the definition of FDI and data compilation methods cannot explain away the huge difference in inflows between China and India.

      MOF (2005c) frankly admits that there is a lack of enthusiasm among foreign investors for investing in India, “the reason being, after independence from Britain 50 years ago, India developed a highly protected, semi-socialist autarkic economy.  Structural and bureaucratic impediments were vigorously fostered, along with a distrust of foreign business.  Even as today the climate in India has seen a sea change, smashing barriers and actively seeking foreign investment, many companies still see it as a difficult market.”  It recognizes that underestimation of complexities of investing in India and/or overestimation of the country’s potential by investors can lead to failure.  Among the complexities and difficulties it notes include:

·         Infrastructural hassles – Problems include power demand shortfall, port traffic capacity mismatch, poor road conditions (only half of the country’s roads are surfaced), low telephone penetration (1.4% of population).

·         Indian Bureaucracy – Although the Indian government is well aware of the need for reform and is pushing ahead in this area, business still has to deal with an inefficient and sometimes still slow-moving bureaucracy.

·         Slow Pace of Economic Reforms – The general economic direction in India is toward liberalization and globalization.  But the process is slow.  Before jumping into the market, it is necessary to discover whether government policies exist relating to the particular area of business and if there are political concerns which should be taken into account.

The complexity of India’s foreign investment (FI) policy reflects continuing ambivalence about the role of such investment in promoting growth and social objectives.  Automatic approval of FI is allowed only in some industries, although the list of eligible industries is expanding.  There are ceilings on foreign ownership, although again these ceilings continue to be raised.  In certain cases, the ceilings now range from 51% to 74%, and in a limited number, 100% foreign ownership is permitted.  Until recently, Indian companies needed prior clearances form the Reserve Bank of India before issuing equity to foreign investors.  The facts that only in the latest budget the Financing Minister announced the government’s commitment to a 90-day period for approving all FI, and set up bureaucratic mechanisms for time-bound clearances at the central and state government levels, and that policy changes reducing the discriminatory bias against foreign firms are also recent, indicate that the climate for foreign investors has been lukewarm if not exactly hostile for a long time.

            There is still a long way to go before the climate becomes welcoming.  Some revealing information is available from the World Bank’s project benchmarking the regulatory cost of doing business in 145 economies (World Bank 2004a):  it takes 425 days to enforce a contract in India as compared to 241 days in China and 27 days in Tunisia (the lowest); the cost of enforcing a contract is 43% of gross national income per capita in India as compared to 25% in China and 4% in Norway (the lowest); time to go through insolvency is ten years in India, 2.4 years in China and 0.4 years in Ireland (the lowest); and recovery of assets is only 12.5% of value in India, 35.2% in China and 92.4% in Japan (the highest).

            The same study reports substantial differences within India across states in each of the above indicators.  A related study (World Bank 2004b) based on two surveys carried out in India by the Confederation of Indian Industry in collaboration with the World Bank in 2000 and 2003 reports other indicators which confirm that even after nearly 15 years of reform, investing in India by domestic and foreign private investors still involves dealing with some formidable obstacles.

2.5.4  Special Economic Zones

            The latest policy initiative that in part could influence foreign investment is the passage of the Special Economic Zone (SEZ) bill by the lower house of Parliament on May 10, 2005.  The bill is expected to “give a big push to exports and foreign direct investment [and encourage] public-private partnership to develop world-class infrastructure, attracting domestic and foreign private investment and boosting economic growth, exports and employment (Hindu 2005a).  There is no doubt that the spectacular success of China in attracting foreign investment and becoming the world’s fourth largest exported through its SEZs must have influenced this initiative.  Whether India’s own experience with export processing zones is recognized and allowed for in the new legislation is hard to say.  After all, India was one of the earliest among developing countries in establishing an export processing zone in the port of Kandla long ago, and established similar zones later.  These zones did not achieve the results expected from them. 

      The main reason for the failure was, in effect, the unwillingness of policy makers to exempt such zones from the crippling controls applied elsewhere in the economy.  For example, unlike China which allowed 100% foreign ownership, and gave complete freedom for the enterprises in hiring and firing of workers in the SEZs, the India Bill incorporates “the amendments suggested by the Left parties to ensure that States can take decisions on the extent of flexibility in labor laws . . . [and] the Government would not allow any violation of labor laws within the SEZ” (Hindu 2005a).  The bill offers many tax concessions:  “The units will now be eligible for 100 per cent income tax exemption for five years, 50 per cent for the next five years and 50 per cent of the ploughed back export profits for the next five years.  The SEZ developers continue to get 100 per cent income tax exemption for 10 years in a block period of 15 years” (Hindu 2005a).  Procedural bottlenecks are to be removed through a single window clearance and approval mechanism to establish the SEZs as well as production units within them.

            It is true that the Software Technology Parks, which are the analogues of SEZs for the IT sector, did achieve their objective of promoting investment and exports.  Whether this success will be repeated in the SEZs is an open question.  A recently published study (Moran et al.. 2005) based on an analysis of FDI flows points out that on the one hand:

When FDI occurs under reasonably competitive conditions—in particular, with low barriers to trade and few restrictions on operations—foreign firms, or multinational corporations (MNCs), can help the host country conduct activities its economy is already engaged in more efficiently.  Or—even more valuable—FDI can bring entirely new kinds of activities into the host economy, changing the production possibility frontier—the development trajectory—available to the country.  Far beyond simply adding more capital to a host economy, FDI can be the conduit to the cutting edge of research and development (R&D), production technology, and management expertise in use around the world.  FDI truly becomes “trade on steroids” with strongly favorable—not harmful—implications for host country development (Moran et al. 2005, p. 375).

On the other:

FDI in protected host country markets leads to an inefficient use of local resources and subtracts from local economic welfare.  Foreign investors in countries with domestic content, joint venture, and technology sharing requirements deploy production techniques lagging far behind the frontier in international industry.  Foreign affiliates with older technology and less efficient plants are not good candidates to develop from an infant industry to a robust world competitor (Moran et al. 2005, . 376).

            Unfortunately, India is still one of the most protected countries in the world.  The constraints on the investment discussed earlier might not be overcome by the tax concessions offered in the SEZs.  The explicit exclusion of any deviation from the draconian labor laws in the SEZs is a pointer in this direction.  Also, offering such concessions have to be justified in the first place by the potential externalities that investors create but cannot capture for themselves.  There is some empirical support for this having happened in Indonesia (ibid, Chapter 4).  Also, unlike in the past when the investors did not respond much to local incentives including tax concessions, recent data show greater responsiveness and sensitivity to tax incentives is particularly pronounced for export-oriented investment (ibid, p. 382). 

Moran et al. (2005, p. 378) argue that the Chinese SEZs were originally meant to be experiments with economic reforms but over time they:

Became what amounted to havens for foreign investors, where these investors received special treatment, including most importantly insulation from the stultifying regulations associated with Communist doctrine.  The zones also provided much-upgraded infrastructure, particularly in telecommunications and logistics, than was available elsewhere in China.  At the same time, the Chinese central government in Beijing allowed local governments to engage in “policy experimentation” in the zones in their territories, with this experimentation turning into effective “policy competition” as each zone tried to make itself more attractive to foreign investors than competing zones.  This included some positive incentives for investors, including tax relief, duty-free importation of capital goods, and provision of trained workers.  Finally, it included insulation from much of the corruption that had become endemic in the largely state-owned industrial sector of China (Moran et al., 2005, p. 378).

            It is possible that the flexibility envisaged in the SEZ Bill for the states could blossom into Chinese-style competition and experimentation among states.  Even if it did, there is a distinct possibility that the competition might turn into a “race to the bottom,” with each state trying to outdo others in offering concessions and, in the end, investors’ location decisions are unaffected but resources are transferred from taxpayers to investors.  The Finance Minister in his inaugural address to the Annual Session of CII (Hindu 2005b) recognized that foreign investment and inflows would stand choked if the door were kept shut or opened narrowly.  Yet he did not commit to opening the retail sector for FDI, as China has done, saying that the issue was still at the discussion stage.

            There is a deeper policy issue that needs to be thought through in creating SEZs within which a different and more investor friendly policy regime is put in place as compared to the one for the rest of the country.  The positive externality of foreign investment mentioned above (except possibly of agglomeration externalities, if any) call for public policy interventions but not for restricting their application to particular areas.  In other words, the objective of national policy ought to be to attract FDI into India if it is socially worthwhile, and not necessarily to particular regions within India.  In other words, the whole of India ought to be the economic zone for this purpose!  A plausible reason for creating SEZs is more a confession of failure, rather than a rationale—it would take longer and be more difficult (politically?) to create a policy environment hospitable to investment in the country as a whole and therefore, creating such an environment in SEZs is the easier option. 

Imitation may be the best form of flattery, but imitating China’s SEZs that were set up in a socio-political-economic environment which is very different from India’s is not necessarily the best way to go forward.  In particular, the insulation of SEZs from the “stultifying regulations” operating in the rest of the economy as China did is not easy in the Indian political system.  Provision of upgraded infrastructure to SEZs in India is also more difficult.  This is not to say, however, that China’s policies particularly regarding FDI and outward orientation have no relevance for India.  Quite the contrary.[4]  But instead of learning from China’s experience, and carefully examining why appropriate policies cannot be formulated and implemented in the whole country, merely creating SEZs may set India up for disappointment.  I hope I am wrong.

2.5.5  Exchange Rate and Reserves

            Foreign reserves continue to accumulate and reached $143.8 billion on 28 October 2005.  This is in large part due to the fact that the Reserve Bank of India (RBI) has been purchasing foreign exchange from the market so as to prevent the exchange rate of the rupee appreciating.  At the same time, the RBI has engaged in sterilizing the monetary impact of its accumulation of foreign reserves by selling some of its holdings of government securities.  As the reserves continued to accumulate, the RBI faced the prospect of its running out of securities to sell.  A new and special arrangement, called Market Stabilization Scheme, was created to tackle this problem.  It is clear that the sterilization operation cannot go on indefinitely.

            India is not alone among emerging market economies which de facto keep their exchange rates unchanged even though their currencies ostensibly float.  This is not the occasion to delve into the reasons for their fear of floating (Calvo and Reinhart 2002).  Whatever be the reason for this fear, the resulting accumulation of reserves, far above what would be needed to smooth out fluctuations in export earnings and import costs and for self-insurance against financial crisis due to contagion from abroad, has a cost.  The return on reserves which are largely held in the form of US government securities and similar low yielding assets at best would be around 3% a year.[5]  The fact that by continuing to accumulate reserves, India is investing in assets that yield such a low return implies that either there are no investment opportunities for India that would yield a higher rate of return or there are other constraints that prevent the availing of such opportunities.  It is hard to believe that there are no domestic investment opportunities either in the public or private sector that would yield higher than 3% risk adjusted rates of return.  The cost of reserve accumulation is in the form of foregone growth:  rather than investing more at home and accelerating the growth rate, the economy’s growth rate has been kept stagnant at about 6% on average.  Growth momentum is yet to be regained from what it was when it began to stall in 1996-97.

            I argued earlier that a poor investment climate, rather than scarcity of investable resources, that restricts India’s private sector from investing more.  One of the prime causes of the poor investment climate is the poor state of a crucial infrastructure, namely electric power.  The prospects in the near future of attracting significant private (domestic or foreign) investment is stymied by the continuing failure to clean up completely the mess in the state electricity boards and to allow truly independent regulatory agencies to function.  It is a pity that the reforms promised in the Electricity Bill passed in 2003 appear to be still on hold.  In the meantime, there seems to be no alternative to large public sector investment in infrastructure, including in electricity generation.  Such investment will not only raise growth by increasing the availability of infrastructural services but also crowd in private investment.  Given the precarious fiscal situation of the country, deficit financing of even such worthwhile investment is risky.  However increasing public investment by utilizing part of the resources held up in low yielding foreign reserves, without at the same time worsening the fiscal situation and affecting the exchange rate significantly is a possibility.  In fact, it is under discussion.  It is certainly not beyond the team of economists who are in charge, including the Prime Minister, the Deputy Chairman of the Planning Commission and their economic advisers to devise macroeconomic policies to achieve this objective.

3.  Social Sectors and Implementation of National Common Minimum Program

The Finance Minister in his budget speech on February 28, 2005 naturally claimed to have “risen to the challenge and carved out many successes” in carrying out the mandates of NCMP, in particular in achieving a GDP growth rate of 6.9% in 2004-05, reducing inflation and restoring business confidence.  He further claimed to have “fulfilled many of our promises to the common citizen,” (GOI 2005, p. 2-3), including expansion of agricultural credit, credit to self-help groups, education loans, and number of families covered under the Antyodaya Anna Yojana.  As promised, a National Rural Employment Guarantee Bill was introduced in Parliament.  .

The overarching objective and whole purpose of any government in a poor country such as India cannot but be, as the Finance Minister stated, the “elimination of poverty and give to every citizen the opportunity to be educated, to learn a skill and to be gainfully employed.  The Government holds that as its sacred duty to empower and eliminate the scourge of poverty” (GOI 2005, p. 3-4).  Agreement on this objective does not imply agreement on policies proposed to be pursued for achieving the objective.  Reducing inflation and accelerating the rate of growth contribute towards achieving the objective, although on the latter, there has been some debate generating more heat than light.  The distinguished Deputy Chairman of the Planning Commission, Sardar Montek Singh Ahluwalia, is reported to have said recently that he regretted that poverty reduction was not achieved to the desired extent during the years of planned development and that “growth has not been even among all sections.  The benefits of growth have trickled down differently among different sections and classes of people” (Hindu 2005c, emphasis added).  If by “the years of planned development” he meant 1950-1980, he certainly is right; there was no reduction in poverty, but there was not much growth either.  In using the well-worn cliché “trickle down,” he seems to have ignored the fact that right from the work of National Planning Committee of the Indian National Congress headed by Pandit Jawaharlal Nehru, in India the process of growth was not viewed as a “trickle down” from the top, a phrase that conjures up an abhorrent image of crumbs from the rich man’s table falling on the poor, but instead as one of “pulling up the bottom,” to use Jagdish Bhagwati’s felicitous phrase of enabling and assisting the poor to climb out of poverty permanently.  In any case, poverty began to decline in India only when per capita GDP growth began to accelerate from its measly 1.5% per annum as an average during 1950-1980.  Let me hasten to add that the Deputy Chairman seems to have said some unexceptionable (banal?) things as well, such as that poverty is not merely income poverty but has to encompass acute deprivation, the growth process could be made more include and be promoted in such a manner that it benefited the poor and other vulnerable sections.

In his budget speech, the Finance Minister did not refer to two major promises of NCMP, namely raising expenditure on education to 6% from its current level of 4.16% and on health to 2-3% of GDP from 0.8%.  Certainly, additional expenditures on education and health, if they result in increasing educational attainments and health status of the population, particularly of the poor, would contribute not only to growth but importantly to enabling the poor to climb out of poverty permanently, in contrast to transfers that only alleviate their poverty temporarily.  However, there is evidence that failure to improve the health and educational attainments in the past is due in part to poor functioning of the public delivery system.  This is not to say that until the deficiencies in the public delivery system are remedied, no additional expenditures should be undertaken, but only to caution against expectations of dramatic improvements in health and education from such expenditures.  In addition to the likely modest outcomes from the additional expenditures, unless additional revenue is found or other expenditures reduced for financing them, fiscal deficits will rise, worsening an already bad situation.

            Turning to the Employment Guarantee Bill that is currently under consideration in Parliament, the cost of providing the guarantees promised in the NCMP in all districts of India is estimated at about 1.27% of GDP.  Nearly two decades ago, my coauthors and I simulated the quantitative implications for growth and poverty alleviation of several employment generation programs, under alternative assumptions about their productivity efforts and the leakage (to non-poor) propensities (Narayana et al., 1988).  We found that a rural works program, designed to provide employment during slack agricultural seasons “through the creation of productive assets such as roads, irrigation works, schools, etc., . . . if carried out efficiently and financed in a way that does not jeopardize long-term growth, can be a very effective instrument for alleviating rural poverty in India” (p.131).  However, my most serious concern with the employment guarantee program (EGP) under consideration now is not so much its possible leakages to the non-poor or inefficiencies in its implementation or its increasing the fiscal deficit, though I do not wish to minimize them.  My most serious and deeper concern is analogous to the one I raised about SEZs in the previous section.  EGP:

could become a permanent transfer programme to alleviate poverty, and to the extent it is successful, it could divert attention from addressing the fundamental issue of eradicating poverty.  Creating employment opportunities otherwise unavailable is certainly an appropriate short-term measure.  But the long-term solution is to create an economic, political, and social environment in which the economy generates productive employment opportunities in a sustained manner, for wage earners, casual workers, as well as the self-employed (the largest single source of employment for our work force) including women, and take children out of work and keep them in schools. . . . In [such] an environment conducive to the generation of productive opportunities in the normal course, the economy would be growing at a rapid and sustainable pace, and the fruits of growth would be widely shared.  The social environment, obviously, would be free of any discrimination based on caste, class or sex.  The political environment would be a thriving participatory democracy with efficient and incorruptible judicial and administrative systems (Srinivasan 2005b).

A necessary, though hardly sufficient, step towards creating such an environment is to expeditiously implement the remaining items in the current reform agenda.  It is also essential to widen as well as deepen the reform process.  I turn to these issues in the following section. 

Let me conclude this section with a reference to another large program for building infrastructure, especially in rural areas.  In his budget speech, the Finance Minister (FM) referred to the President having named it as “Bharat Nirman” in his address opening the budget session of Parliament.  It is conceived as a business plan, to be implemented over a period of four years, with six components:  irrigation, roads, water supply, housing, rural electrification, and rural telecom connectivity.  The FM announced a set of “bold” targets in each of these areas to be achieved by 2009 (GOI 2005, p. 8).  Two weeks ago, the committee on Rural Infrastructure approved the Bharat Nirman, during 2005-2009 (Hindu 2005d).  The desirability of investment in infrastructure, particularly rural infrastructure, is clear.  However, as in the cases of EGP, the financing of roughly 1.25% of GDP in each of the next four years, without addition to fiscal deficit, and also the ability to design and efficiently implement another large program are serious concerns.

4. Conclusion

In the time honored tradition of governments of India since the colonial days, the United Progressive Alliance government that came to power in 2004 has set up a large number of National Commissions and committees, headed most often by cabinet members and consisting of members bestowed with the rank of Minister of State or Secretary to the Government.  (India Today, 16 May 2000). What is most disturbing is that several panels seem to be charged with studying problems that have been studied by several committees earlier.  For example, according to the article, six committees had earlier studied employment issues, four committees and a task force headed by the Deputy Chairman of the Planning Commission had studied infrastructure, and so on.  At best, which is unlikely, the new panels could take on board the findings and recommendations of earlier panels and come up with actionable recommendations.  At worst, which cannot be ruled out, any action will be delayed until the committees deliver their reports, then a committee of secretaries will review the reports and recommend decisions for the cabinet’s consideration, and the cabinet will finally decide on them.  Of course, implementation of the cabinet’s decisions is yet another story.  One cannot help wondering whether all this is simply an exercise in political patronage and rewards to superannuated bureaucrats, economists and politicians.  I do not want to begrudge rewards to the eminent worthies any more than I would to the leading opposition party proposing to build “Go Sadans” for aged cows!  But what is needed now is concrete action and not a hiatus in the reform process; I do worry whether needed urgent action on several items of the reform agenda so as to accelerate the process will be unduly delayed while awaiting the reports of the panels.

            Among the major items of the agenda of reforms of 1991 was the opening of the very insulated and autarkic economy to foreign competition and investment; liberating the financial sector from repression that characterized it for decades; doing away with public sector monopoly in some areas and starting disinvestment of public equity in others; creating appropriate regulatory agencies; and fiscal consolidation.  In each of these items, reforms seem to have stalled and need to be completed urgently.

            First, on the external sector, I have already alluded to India being one of the most protected economies in the world.  Several finance ministers promised to bring down the tariffs to East Asian levels and none delivered.  There is absolutely no reason for not doing so immediately, notwithstanding the adverse impact in the short run on customs revenues.  There are a plethora of non-tariff barriers by way of various permissions required in export and import activities at the central and state levels that need attention.  Although, according to A. K. Kearney (2005), China and India are challenging the United States as the world’s favored destination for FDI, the reality is that the poor investment climate in India continues to be a deterrent.  The causes of the poor climate, particularly the role of the dead hand of bureaucracy at the central and state levels, are well known and need to be addressed.

          India is a member of the so called “ quad “, the others being Brazil, the EU and the US whose negotiating stance can make or break the Doha round of Multilateral trade negotiations.  Unfortunately, it now appears that the momentum that was expected to come from the December 2005 ministerial meetings of the WTO in Hong Kong will not be.  India’s negotiating position continues to reflect the historic lack of confidence about India’s ability to compete effectively in a liberal global trading system.  We continue to insist on Special and Differential Treatment as a developing country rather than be subject to a set of common rules and ask for liberal access to developed country markets while retaining flexibility to restrict access to our markets and other such demands.  We have availed ourselves to the maximum extent such measures as the WTO agreements would allow to protect our markets.  It is nothing short of scandalous that India has initiated the largest number, 397, of antidumping measures in WTO’s history (January 1995-December 2004), followed by the United States (353) and the EU (303) (WTO 2005b)!  These attitudes and actions have to change drastically.  India is joining most other members of the WTO in trying to negotiate and enter into preferential trade agreements.  The so-called South Asian Preferential Trade Agreement (SAPTA) and a free trade agreement with Sri Lanka are already in force.  Apart from the limited benefits from liberalizing trade on a preferential basis, a push towards such agreements could come at the expense of multilateral liberalization from the speedy conclusion of the Doha Round.

            The Finance Minister, in his inaugural address to the Annual Session of the CII (Hindu 2005b), recently dwelt on the need for speedy reforms while pointing out that the first thing to be done would be to complete the agenda of financial sector reforms.  Here again, there is no dearth of ideas as to what needs to be done.  Rakesh Mohan (2004), former deputy governor or RBI, has reviewed the reforms and raised issues for further action.  The present governor, Dr. Y. V. Reddy (2005), also recently addressed the issues.  Deputy Governor V. Leeladhar (2005), in his discussion of contemporary and future issues, pointed out that only twenty Indian banks, including private sector banks, appear in the list of top 1,000 World Banks and India’s largest bank, the State Bank of India, ranks 82^nd among top global banks and it is not even tenth in size of the ninth largest bank, Sumitomo Mitsui.  I would argue that continuing dominance of public ownership of commercial banks is not conducive to Indian banks becoming major players in the global banking industry.  The well-known problems of “too big to be allowed to fail” syndrome, as exemplified by repeated capital infusions into poor performing banks, and political interference in credit allocation decisions and other endemic characteristics of India’s public sector banks would continue as long as the majority of ownership and control of banks are in the hands of the government.  Hopefully, sooner rather than later, disinvestment of equity in public sector banks will go much farther than it has gone thus far.

            Indian rupee is convertible only for current transactions and capital controls are in place.  Although such controls have been relaxed considerably for inward movements of capital, it is unlikely that the rupee will be made fully convertible in the foreseeable future.  Of course, until the financial sector reforms are completed and the financial system is in a position to absorb external shocks smoothly, capital account convertibility is risky.  However, committing to such convertibility at a specified, but not too distant, future date is desirable as a device for credibly committing the financial sector reforms in a timely manner.

            The precarious fiscal situation calls for completing tax reforms and also rethinking our fiscal federalism aspects.  Acharya (2005) has pointed out that not only has tax reform been studied by several committees but also considerable progress has been made in implementing their recommendations.  What is needed now, is to finish the task.  Ensuring that those states which have opted out of introducing VAT on 1 April 2005 should be persuaded to do so soon, and the problem that have been encountered in implementing VAT without creating distortions have to be addressed.  On fiscal federalism, it is worth recalling that the constitutional assignment of tax bases and expenditure responsibilities that were decided more than five decades ago in 1950, when the constitution was adopted.  They have largely remained intact, even after some amendments.  Although the Constitution did not mandate it, the Planning Commission was also set up in 1950. It has since become a major agency in making centre-state transfers, a role that was assigned by the Constitution to the Finance Commission.  In addition, central ministries also make transfers to states in financing centrally-sponsored schemes.  Although the rationale for continuing to plan as was done for five decades does not exist any more, central and state planning commissions continue to exist.  The rituals of formulating five year and annual plans with the Planning Commission approving annual plans for states and associated transfers in support of approved plans continue to be observed.  Moreover, external funding agencies, such as the World Bank, are now dealing with the states directly to a far greater extent than earlier.  Also the access of states to capital markets, the procedures associated with the approval of state bond issues, and the role of the Reserve Bank of India in all this, have been changing.  It is time now to rethink not only fiscal federalism but also issues relating to the independence of RBI from the finance ministry, as well as to access to bond markets by the centre and state.  Some of the issues have been already studies (see Singh and Srinivasan 2005) for a survey of fiscal-federalism).  What is needed now is a comprehensive and integrated discussion of all the relevant aspects, such as taxes, expenditures, borrowing (domestic and foreign), and transfers.

            Let me conclude with the festering issue of disinvestment/privatization of public enterprises.  On a historical cost basis, the equity held in public enterprises (directly or though holding companies) by the central government was Rs. 78,484 crores as of 31 March 2000.  The total investment in state level public enterprises as of the same date was three times as much, at Rs. 252,242 crores.  These are staggering amounts (MOF 2005d, DOD 2005).  The issue is whether the society is reaping adequate returns from the huge investment.  It is sad that intelligent and rational economists sometimes seem to succumb to the deceptive and specious argument that market profit-loss considerations, rather than social cost-benefit rationale, should determine whether an enterprise continues to be owned in the public sector or to be brought into the public sector if it is not.  The NCMP categorically rules out privatizing the so-called “Navaratna” (Nine Gems) companies, which are very large and earn profits.  Interestingly, the Ministry of Finance (MOF 2005d) tries to refute the argument that a profitable public enterprise in a competitive market should not be privatized, and one which is profitable, only because of its exercise of market power could be privatized are not relevant.  Its refutation is not through an examination of the rationale of the argument but by showing that the government made more money by privatizing them from the profits the enterprises were contributing.  A rational basis for privatization decisions is to apply social-cost benefit calculus so that a public enterprise should not be privatized if retaining it in the public sector will yield a higher net social benefit compared to privatizing it, taking full account of the market structure of the industry.  For example, turning a profit making public monopoly into a private monopoly is not likely to yield significant net social benefit. 

            A National Investment Fund has been created into which the realization from sale of minority holdings in profitable enterprises would be deposited, with the fund being managed professionally outside the Consolidated Fund of India.  The Fund will invest in social sector projects and selected public enterprises.  The Fund seems to have been created more as a response to critiques of privatization, rather than on the basis of any analysis of the alternatives to the use of sale proceeds from public equity.  It is not obvious that social returns to public resources from investments of the fund would be higher than those from using them to reduce the budget deficit or public debt.  In any case, it is high time that a proper social cost benefit evaluation of India’s public sector enterprises is undertaken.

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---.  2005b.  “Guaranteeing Employment:  A Palliative?” The Hindu.  http://www.hindu.com/2005/01/03/stories/2005010301861000.htm, January 3, 2005.

World Bank.  2005.  World Development Indicators.  Washington, DC:  World Bank.

---.  2004a.  Doing Business in 2005:  India Regional Profile.  http://rru.worldbank.org/doing business, accessed 23 May 2005.

---.  2004b.  India:  Investment Climate Assessment 2004, Improving Manufacturing Competitiveness.  Washington, DC:  The World Bank.

---.  2000.  India:  Policies to Reduce Poverty and Accelerate Sustainable Development, Report No. 19471-IN. Washington, DC:  The World Bank.

WTO.  2005a.  International Trade Statistics.  Geneva:  World Trade Organization

---. 2005b.  “AD Initiations by Reporting Member from 1/1/95 to 3/12/04.”  http://www.wto.org/english/tratop_e/adp_e/adp_stattab2_e.pdf , accessed 24 May 2005.

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* Samuel C. Park, Jr. Professor of Economics, Yale University. This paper is being presented at the Conference on  Economic Development and National Security:  The Case of India, Washington, DC, November 16, 2005.   It is a revised and updated version of my paper “Economic Performance Reforms:  First Year of the UPA Government” presented at the “Sixth Annual Conference on Indian Economic Policy Reform”, Stanford University, June 3 &4, 2005.

[1] The details of the three categories are: 

·         Merit I – Elementary education, primary health-care, prevention and control of diseases, social welfare and nutrition, soil and water conservation, economy and environment.

·         Merit II – Education (other than elementary), sports and youth services, family welfare, urban development, forestry, agricultural research and education, other agricultural programs, special programs for rural development, land reforms, other rural development programs, special programs for north-eastern areas, flood control and drainage, non-convention energy, village and small industries, ports and light houses, roads and bridges, inland water transport, atomic energy research, space research, oceanographic research, other scientific research, census surveys and statistics, and meteorology.

·         Non-Merit – All others.

[2] It is a pity that even after two expert committees (the Raj and Chelliah Committees) and the National Statistical commission have documented the inadequacies of such basic macroeconomic data as savings and investment, there has been very little change in the basic methodology of estimation.

[3] The US is among 30 or more members of the WTO who are signatories to the plurilateral code on government procurement.  The New Jersey measure could be in violation of the code.  However, since India is not a signatory to the code, it cannot avail itself of the provisions of the code to dispute the measure.

[4] In his budget speech, the Finance Minister urged the members of Parliament to take a pragmatic view on FDI and said, “At the recent meeting of the Finance Ministers of G-7 countries, to which India and China were invited, the Finance Minister of China looked in my direction and told the gathering that China had received US$500 billion worth of foreign investment since China opened its economy in 1980.  Of this, nearly US$60 billion came in calendar 2004” (GOI 2005, pp. 15-16).  Presumably he implied that China had been pragmatic in not letting Communist ideology come in the way of attracting FDI.

[5] It is odd that poor countries in Asia, including China and India, continue to finance current account deficits of one of the richest countries of the world, namely the US, by continuing to add US government securities to their reserves.