The Hindu Business Line : The reform story so far

Although the achievements in several sectors and the recent acceleration in economic growth are undoubtedly a consequence of the reforms since 1991, they are also the result of the unusually favourable external economic environment. If this environment becomes unfavourable, it could hit India's growth rate, says T. N. SRINIVASAN.

The Indian economy has undergone an extraordinary transformation since the mid-1980s. It has decisively broken away from the lacklustre growth of 3.5 per cent per year on an average for the three decades 1950-80, to become one of the world's rapidly growing economies. World Bank data show that the average annual rates of growth of India's real GDP were 5.7 per cent during 1980-90, 6 per cent during 1990-00 and 6.9 per cent during 2000-05, as compared to the weighted average growth rates of real GDP of low income countries (including China and India) during the same three periods of 4.4 per cent, 5.0 per cent and 5.6 per cent respectively.

Between 2003-04 and 2005-06 India's rate of growth accelerated to 8.2 per cent a year. The latest estimate for the second quarter of 2006-07 is an even higher 9.2 per cent, with the growth rate for the first half being 9.1 per cent.

This impressive performance was driven not just by growth of 10 per cent a year since 2003-04 in service sector output. The manufacturing sector has broken out of stagnation to grow at an average of 8 per cent during the three years from 2003-04 to 2005-06, and even faster at 11.6 per cent in the first half of 2006-07, comparable to the 11 per cent rate per year during 1993-94 to 1996-97.

Foreign exchange reserves crossed $176 billion on December 22, 2006. India's external debt, currently at less than 15 per cent GDP, is the second lowest among the top 15 debtor countries. In comparison, at the depth of the macroeconomic crisis of 1991, reserves hit a low of $1 billion in August. India avoided the acute embarrassment of default on external debt only by pledging the country's gold stocks with the Bank of England.

In the first half of 2006-07 the growth of merchandise exports, at 23 per cent in US dollar terms, and of net invisible exports, at 29 per cent in US dollar terms, are robust with a significant contribution from the growth at 58 per cent (169 per cent) of gross (net) receipts from exports of software and business services.

India is now a global player in information technology, business process outsourcing (BPO), telecommunications and pharmaceuticals. It is attracting engineering services, knowledge process outsourcing and also foreign users of health care services.

Data from the 61st round of NSS indicate that the poverty rate is around 22 per cent in 2004-05 as compared to 50 per cent in 1977-78. In 2000-01, adult literacy among males of over 5 years in age averaged 76 per cent, with females still lagging behind at 47.8 per cent, as compared to 27 per cent and 9 per cent respectively in 1950-51.

Substantial reduction in poverty and improvements in social indicators occurred only after the rate of economic growth accelerated following the opening of the economy to foreign trade and investment and the abandoning of four decades of insulation from the world economy.

Sustaining growth

Sustaining, nay accelerating, the recent growth rate, over the next couple of decades is essential if poverty is to be eradicated once and for all. Although the recent growth acceleration is undoubtedly a consequence of reforms since 1991, it is also in part a result of the unusually favourable external economic environment. This environment could become unfavourable and adversely affect India's growth rate.

Thus, India faces a two-fold challenge. First, the stalled reform process has to be revived and completed. Second, it is essential that the increasingly outdated institutions of economic decision of 1950s vintage are reformed and made relevant to the vastly changed political and economic environment of the early 21st century. The major components of reforms are unlikely to be reversed. With respect to the external sector these include:

Substantial reductions in tariff and non-tariff barriers to merchandise trade with the abolition of import licensing and quantitative restrictions;

Creation of an enabling environment for exploiting the opportunities for exports of services, in particular through major reform of telecommunications; determination of the exchange rate of the rupee largely by the market, with the rupee freely convertible for current account transactions and for most capital inflows;

A timetable for the likelihood of capital account convertibility in five years; and

The creation of special economic zones (SEZs) based on the successful Chinese model, and attracting export-oriented FDI through them.

IT-enabled services

In the industrial sector, investment licensing has been abolished and the draconian restrictions of the Monopolies and Restrictive Trade Practices (MRTP) Act liberalised; instead of fearing competition from imports and seeking protection, industry is not only becoming competitive in export markets, but also in investing and acquiring firms abroad; last, there are signs that India is becoming a destination for off-shored manufacturing and a major exporter of manufactures such as auto components (and even automobiles).

The phenomenal success of the reforms in telecommunications, relaxation of imports of computer hardware and software since the mid-1980s, and the creation of software technology parks enabled the growth of information technology enabled services (ITES). This has helped India become a global player in the sector; the composition of the ITES has been shifting from exclusive dependence on low-end products to more advanced ones.

Foreign IT companies are setting up research and development centres in India for the design and development of advanced products. In 2005-06 the sector accounted for 61 per cent GDP, far exceeding its expected share for a country of India's per capita income.

Financial reforms

The reform process in the financial sector, though cautious and steady, has transformed it enormously. Interest rates are largely market determined (except for a floor set by the administered rate on small savings).

In the conduct of monetary policy, instruments such as repo and reverse repo rates have replaced the traditional bank rates. There are well-functioning primary and secondary markets for public debt, though the market for corporate bonds is virtually non-existent; many new financial products are available, including housing mortgages.

Transaction costs at the National Stock Exchange (NSE) are even lower than in the New York Stock Exchange. Forward trading in commodities is no longer restricted and a regulatory authority for forward markets has been established. The reform process has not covered agricultural and social sectors (education and health) to any significant extent.

Demographic dividend

Remarkably, a less frequently noted, but nonetheless significant positive for India is its demographic profile. According to the UN Population Division, during 2005-2050, the share of working age (15-59) persons in India's population is expected to increase slightly from 60 per cent to 61 per cent, whereas in China it is expected to fall from 67.7 per cent to 53.5 per cent; the dependency ratio expected to fall slightly in India and to rise in China. This, and the possible rise in labour force participation (particularly by females) will contribute to rising savings and investment rates and, hence, to higher growth rates.

With more than 60 per cent of India's labour force currently engaged in low productivity primary activities, the potential for growth from their shift to higher productivity activities in the secondary and tertiary sectors is high. With the population of rich countries not only static (except in the United States) but also aging, India could attract offshoring in labour-intensive manufacturing and services.

This so-called "demographic dividend" is, of course, highly dependent on the country's effectively facing the twofold challenge of completing the 1991 reform agenda at the earliest and undertaking deeper and long-term institutional reforms.

(To be continued)

(The author is Samuel C. Park Jr. Professor of Economics at Yale University.)