Sunday, 29 December 2013

Liberalization and Its Impact on the Indian Economy

The Economic reforms currently underway in India represent both continuity and a break with India's post-independence development. Its main objective is to restore sustained high growth to alleviate poverty and raise the standard of living.
Development of Thought:
Changes in the policy packages towards deregulation, liberalization and opening up of the economy were initiated in the late 70s and early 80s but it was not until 1991 that major economic reforms were undertaken. The major changes in India's economic reforms fall broadly under five heads-industrial, trade, financial, fiscal and monetary.
However these measures of stabilization are not by themselves enough. The main impetus for sustainable economic growth has to originate with efficiency and productivity growth brought about through the expansion of investment and exports.
Another important aspect to be considered is the large number of people in the country living on the poverty line. To make any reform process socially acceptable a poverty alleviation programme must be in. In the context of resource constraints, a serious thinking has to be done as to the extent and pace of economic reforms.
India has to go through a painful period of adjustment before the liberalization can have its fruitful impact upon the economy. In liberalizing the economy the government must not forget to protect the poor and the needs of human development.
The present bout of economic reforms in India-those started in the nineties- marks both continuity and a break with India's post-independence development strategy.
India's development strategy after independence was largely influenced by reservation regarding the ability of the market forces to bring about, on their own, an optimum allocation of resources, thus balancing the country's two main "Objectives "growth' and 'equity'.
A realization has since dawned on policy-makers, based on India's own experience and the experience of other countries, that: The domestic economy has now reached a threshold where for better utilization of resources the benefits of the market forces can be harnessed, by proper market-friendly macro and micro- economic policies helping both in higher growth and more equity.
This has initiated a serious debate in the country on our development strategy for opening up the economy and allowing more market orientation, by removing major Government interventions and regulations.
Since 1977, and specially after 1985-86, the Government has embarked upon a series of economic reforms leading towards liberalization and deregulation Subsequently, there has been a significant improvement in the growth rate of the country-from the long existing, low rate of income growth of 3.5 percent to an average growth rate of 5.5 per cent and above.
As noted, the changes in the policy packages towards deregulation, liberalization and opening up of the economy had been initiated in the late 70s and early 80s. These changes were not systematic and were never integrated into an overall framework.
According to many economists, these changes were rather slow but not monotonic, until July 1991 when the new Congress Government came to power. Since then the change in the policy packages have picked up momentum. There have been major changes since July 1991.
The present Man Mohan Singh led Congress Government came into power in 2004. It has further extended the liberalization policy started in 1991. In its 2004-2005 and 2005-2006 budgets, the government has brought along with almost simultaneous changes in trade and finance announced outside the Budget.
These changes are primarily confined to Central Government activities and have not been given an} general policy directive to integrate with the overall policy packages of the State Government.
The major changes in India's economic reforms fall broadly under five heads-industrial, trades, financial, fiscal and monetary. The Government's key economic objective is to restore sustained high growth which is essential to alleviate poverty and raise the standard of living.
In pursuit of these objectives the Government's reform strategy aims at achieving over the course of the next five years:
(1) a liberalized trade regime characterized by tariff rates comparable to other industrializing developing countries and the absence of discretionary import licensing (with the exception of a small negative list);
(2) an exchange rate system which is free of the locative restrictions of trade;
(3) a financial system operating in a competitive market environment and regulated by sound prudential norms and standards;
(4) an efficient and dynamic industrial sector subject only to regulations relating to environmental security, strategic concerns- industrial safety and unfair trading and monopolistic practices; and
(5) an autonomous, competitive and streamlined public enterprise sector geared to the provision of essential infrastructure goods and services, the development of key natural resources and areas of strategic concern.
It involves taking every step necessary to ensure that the burden of adjustment is fairly distributed and that the very poor are protected. As a first step in this direction the Government has established a National Renewal Fund to provide social safety net.
The thrust of the reform programme would initially be on casing the country's extremely tight external payments situation and reducing inflation. In this context, the Government intends to pursue a. stab le exchange rate policy geared to maintain the rupee constant in nominal terms- and to rely on fiscal adjustment accompanied by a tight monetary policy to contain inflation.
But this is an initial phase. Stabilization by itself is not enough. As traditional demand impulses originating from fiscal policy will remain constrained in the next two to three years, the main impetus for sustainable economic growth has, to originate with efficiency and productivity growth brought about through the expansion of investment and exports.
Under-pinning such a path of growth must be a consistent and comprehensive structural reforms strategy designed to promote exports, to improve the relationship between the return on investment and the cost of capital, and to increase the degree competition between firms in the domestic and external markets so that there are adequate incentives for upgrading the technology, improving efficiency and reducing costs.
The main emphasis of the fiscal policy is to reduce the Central Government's fiscal deficit, within the broader context of adjustment of the overall public sector budget.
Reducing the overall public sector budget will require increased financial discipline by the State Government as well, and the Central Government will encourage the State Government to take steps to improve their fiscal performance and to streamline the working of the enterprises.
In this context a comprehensive tax reform is proposed. It will improve:
(i) the elasticity of tax revenue through identification of new areas and increasing the share of direct tax a proportion of total tax revenue,
(ii) a more equitable and broad based system particularly with regard to commodity taxation and personal taxation,
(iii) the removal of anomalies that distort economic incentives and simplification and rationalizations of customs, tariffs, elimination of exemptions as well as a reduction the average level of tariffs and finally improve compliance of direct taxes and strengthen enforcements.
In this context also, the need for rationalization and reduction of subsidies and for moving to a more objective system of administered price has been emphasized.
Regarding exchange rate policy it emphasized the adjustment of exchange so as to provide a significant real depreciation, to improve export incentives and international competitiveness. In this context the Government intended to keep the nominal exchange rate stable by a suitable fiscal and monetary policy.
In the immediate future, to achieve stabilization. Government visualizes a tightening of credit and monetary policies, free higher interest rates and higher cash reserve ratios. It also proposes, by declining the recourse to financial savings the Government, a larger volume of supply of domestic credit to the private sector.
The Government recognizes that trade reform is an essential element securing supply response to facilitate the overall restructuring of the economy and to restore external payment viability.
There are five key medium term objectives in the Government's trade policy agenda:
(1) The broadening and implication of export incentive measures and the removal of restrictions on exports:
(2) The elimination of quantitative restrictions on imports;
(3) Substantial retail in the tariff rates;
(4) The decanalisation of exports and imports with the exception of a few items and finally moving to a foreign exchange system which is free of locative restrictions for trade.
The Government also recognizes that the temporary restriction on import which had to be imposed by the Reserve Bank of India no to be relaxed.
The Government recognized that a major restructuring of Indian economy, implied by its agenda, will very much depend on the success of its industrial policy reforms.
In this context a large number of sick firms which constitute drain on the Government budget, with their unpaid outstanding loans, weaken the financial system, in many cases with the firms closing down leaving their creditors unreimbursed, have to be taken care of.
For the restructuring of existing sick and loss-making companies, both in the public and private sector, Government will review the existing provisions of various laws governing labour relations, the State and the local government's role in restructuring regulation governing transfer of land, the procedure of liquidation under the Companies ACT and other relevant aspects.
The Government is aware that the prerequisite of having a safety net or social insurance scheme is to provide support for displace workers in the organised sector. The Government's industrial policy strategy marks a major step forward towards changing the regulatory structure of industries.
It initiated major changes, including comprehensive deli censing, abolition entry controls related to the MRTP Act and automatic approval of foreign technology agreements and foreign investments, among others.
The changes policies concerning foreign technology and foreign investment will enable Indian industries to forge much more with foreign investors and suppliers of technology than has been possible in the past.
The Government's ownership of the financial and banking institutions enabled it to achieve the multiple objectives of mobilization of resources integration of the rural population into the financial mainstream, enhancement availability of long-term loans to all levels of industry and agriculture and increased access to credit to small industrialists, farmers and weaker sections of sock.
However, there are weaknesses and imbalances. The statutory liquidity ratio and cash reserve ratio levels are high, which implies low return for commercial banks on their funds. This reduces the reserves available to non-priority borrowers and raises their costs in moving to market based operations of the financial institutions.
Measures have been taken to strengthen the capital markets, the rates for debentures have been freed, and mutual funds have been opened to the private sector and the full statutory powers are to be given to independent agencies to regulate security markets. The high level Narasimham Committee had been established to review the structure.
In line with the recommendations of the Narasimham Committee further reforms of the financial sector will be formulated to increase the efficiency of the financial intermediation.
The measures required to meet these objectives would particularly involve a phased reduction of priority lending schemes towards the targeted deserving groups and eventual elimination of the subsidies involved, formulation of prudential norms and standards to guide efforts in recapitalization of the banking sector and full decontrol of deposit rates.
India's severely constrained budgetary circumstances create both the need and the opportunity for placing greater reliance on the private sector for resources mobilization and investment. Public enterprises provide many of the basic and critical inputs in India.
It is a matter of serious concern that inadequate attention has been paid to improving their efficiency. In the context of public enterprise structuring it will be important to assess the social cost involved, with the closure of sick units, and to develop options and measures for compensation of retrenched labour.
Enterprises in areas judged appropriate for continued public sector involvement will be provided with greater degree of managerial autonomy along with a progressive reduction in budgetary transfers and loans. Sale of selected firms or partial divestment for specific sectors is being increasingly, pursued.
The Government recognizes that adjustment programmes entail significant transitional cost. This cost includes potential loss of output, employment and consumption due to the deflationary impact of fiscal consolidation and frictions in the restructuring process which must be equitably borne by all sections of the society.
However, a large proportion of India's population continues to be subject to malnutrition and ill health. For this group, the Government is committed to minimise their share of the burden of adjustment.
Thus the Government should provide higher outlays on elementary-education, rural drinking water supply, assistance to small and marginal farmers, programmes for women and children, programmes for welfare of scheduled caste and scheduled tribes and the weaker sections of the society, and increased expenditure on infrastructure and employment generation projects in rural areas.
Further steps have to be taken to re-allocate social expenditure, particularly in health and education for the poor. Additional cost-effective compensatory programmes, particularly in the areas of nutrition and employment, should be strengthened and broadened.
In this context the establishment of a National Renewal Fund has been proposed. Against this backdrop of proposed policy changes, the first set of changes introduced by the Government comprises increasing of taxes and reduction in Government expenditure, in order to reduce the deficit.
Simultaneously, there have been adjustments in the exchange rates to make exports more attractive and to control imports to narrow the balance of payment gap. Along with this a tight monetary policy was followed. Subsequent assessments however revealed that these measures were insufficient to reduce excess demand for imports.
Consequently, the Government imposed emergency credit restrictions on imports. Unfortunates although the Government took timely measures in the field of trade, industrial policy and fiscal measures, it took a comparatively longer time to introduce financial liberalization measures, public enterprise reform and measures affecting the mobility of labour and capital which are normally known as entry/exit policy.
By introducing all these changes, the Government has been successful in its stabilization attempts to a certain extent. For instance, the foreign exchange reserve has reached 128.9 billion $ on 4 February, 2005, increasing by $31 billion from 2003-04, though it should be realized that this benefit is only a one time gain, resulting primarily from multilateral aids.
Thus a major part of multilateral aid has been used for debt servicing. Even NRI outflow which increased $10.2 billion in 2002-03 to $14.3 billion in 2003-04. Thus, the net inflow is still positive. There are differences of opinion as to the potential adverse effect of attaining stabilization by this method.
For example, to reduce the gap the contribution of export growth has long term stable implications, but resorting to too much import compression, will affect adversely the possibility of export growth, and may prove to be self-defeating, especially if the import component of non-tradition exports is very high.
The 2005-06 budgets further has accelerated the reform process by reducing the deficit to 4.3 per cent of GDP but again by a modest increase in revenue and a heavy reduction in expenditure, especially expenditure on capital formation and on human development. For further reduction in fertilizer subsidy, nothing has been worked out.
With regard to the impact of economic reforms on social expenditure and poverty alleviation it is noted that the reforms have affected public expenditure and many of the key social services areas like health, sanitation, water supply etc. which contribute to the welfare of the poor.
It does not mean that there is no scope for economizing these expenditures but it implies that it should be done carefully. Any across the board reduction may be politically and administratively easy but would be harmful to the poor.
The essence of the present economic reforms, understandably, is to resort to the market and make price corrections according to the relative scarcity values and rates of returns for all inputs in the productive system.
But experience shows that in the long run, when the economy is not growing at a fast pace (i.e., under a concretionary stabilization phase) these price shifts results in the reduction in the reduction in the welfare of some sections of the society while benefiting other sections, both in absolute and relative terms.
The fall in real consumption per has resulted in a significant increase in the level of poverty ratio and accordingly the number of people below the poverty line. A conservative estimate using Planning Commission methodology and database shows that nearly 6 to 7 Billion people went down the poverty line during this period.
This is a contrast with an annual improvement of nearly 10 to 15 million moving above the poverty line over the last decade. Thus overall, it makes a difference in terms of a in the poverty alleviation pace by nearly 20 millions, with reference to the trend values.
This scenario has high political and social sensitivity. In order make the reform process morally and socially acceptable and politically feasible, conscious positive programme on poverty alleviation will be needed. The need for such a programme will be more felt if the message is that the present structural adjustment phase will last for more than 3 to 4 years.
The economic reform process also breeds a class of "new poor". These are the people who will be affected by the restructuring process through 'closures', many of them are at the higher and middle income level, mostly in the organised or and easy to identify.
They are the target groups which can be covered by the National Renewal Fund. In this context it should be noted that already there has been a significant increase in the percent of unemployed.
To provide a cushion to the poor against high price increase, the Government uses the Public Distribution System (PDS); however its effectiveness needs to be improved. For lance:
(I) The inter-State PDS's allocation is made on a per capita basis regardless of income;
(2) within a given area the poor-income groups are not functionally the most important beneficiaries of the PDS. In West Bengal, for ample, the PDS financed 54 per cent of wheat consumption of the rural highest income groups;
(3) the PDS is grossly inadequate, especially in areas with high poverty intensity. The income of the poor is much too low to take advantage even of the PDS; and finally, the whole approach towards impact on the vulnerable section of the society should be reviewed in the light of reduced public expenditure on social programmes.
For example, cuts in the health programme could lead to increase in India's already high incidence of tropical diseases. In addition, a poor location programme has its impact not only on the rural wage of the poor but also in the drive for export growth and adoption of better technology, by making the labour force more illiterate.
The stabilization package is giving the anticipated results: it has also skillfully combined some of the structural adjustment changes. However, the adequacy of the structural adjustment elements and the growth factors in the stabilization programme of the Government has been questioned by many economists.
It is that many of the measures taken are on the soft side, as it does not remove many implicit subsidies. In this context, measures to contain the Government wages bill have not been given proper priority. With regard to taxation, it is felt that even now, the indirect tax rates in India, particularly on imports, are very high compared to other LDCs.
Of the measures on adjustment that have bet implemented, almost all are in the Central Government sector; whereas substantial fiscal deficit exists in the States, almost close to that of the Centre of nearly 1.8 per cent of GDP. More exhaustive measures need to be taken to curtail the States' expenditure pattern.
With regard to the cut in the capital expenditure, is rightly realized that there are many wasteful expenditure items in the present composition of public investment.
One should, however, be cautious not to reduce them indiscriminately, since in this process, along with the unproductive, productive sectors, also may suffer a cut.
The 'exit rules' constraining firms from liquidating their assets or retrench workers, remain major hindrances to improving their efficiency and new investments in the organised sector. Any postponement of a policy in this arc does not fit with the basic philosophy of structural reform and efficiency.
As to the role of foreign investment, they should be given more open-ended facilities since even now there remain a large number of constraints in the form Government restrictions on remittances of profit, and Government's approval required for some major productive sectors.
In the field of financial liberalization a quicker action is needed on the Narasimham Committee's Report. Without a sound financial superstructure the passage to the market system may result problems, as was observed in the stock market debacle very recently.
The financial reforms would strengthen the prudential financial recoveries and allow private banks, foreign and domestic, to bring competition to the financial sector. In the field of agriculture, no specific action has been taken for its betterment.
This is the area where coordination with the States Rector would be required. Public sector needs greater positive reforms in addition to reduction in the capital expenditure as given in the last two Budgets.
The public sector should be allowed to adjust to the new policy frame by focusing on issues like: (i) privatization and (ii) closure of enterprises that would not survive in a competitive environment.
Finally, although India has successfully diversified and expanded its export base, the major contribution in India's export growth has come from the demand pull of the receiving countries (especially the developed countries). Only a vet; small portion can be accounted for by changes in market composition and price competitiveness.
Indeed it is only the price factor and a prudent spread over different markets which can help in further increasing India's exports, in future. This is true especially when the international trade buoyancy does not give rise to much optimism.
However, for increasing exports, apart from reducing domestic costs, the country will-need better links, with the international market. For this efficient transport and communication links will be needed to back our trade an investment policy.
It is the experience of most countries that in the process of reducing costs and improving quality of products the role of literate labour force and skilled manpower should get high priority. Indeed, absorbing higher technology needs a correspondingly well-trained, literate and healthy labour force.
In this context the heavy cut in human development expenditure under the recent budget and the low emphasis on domestic R&D (needed to improve the ability to absorb and indigenize foreign technology) are disappointing.
India initiated the process of economic reforms with several handicaps. A high poverty ratio with nearly 32 to 40 per cent of the population living below the poverty line. A very low foreign exchange reserve and level of confidence about India's credit worthiness.
An unfavorable world scenario with its projected low income growth and increasing regionalism and a substantial loss in RPA trade (Former USSR and Post European countries) for India.
India's hang-up with anti -market socialistic development strategies and people's shaken confidence arising from unsatisfactory sporadic liberalization attempts since 1990s. The existence of a large but inefficient public sector with its own vested interest.
All these, in the light of inter-country experiences, forewarn of a longer gestation period with heavy social costs and raise doubts as to the tolerance level of Indian society for withstanding such less impending social cost.
However, there are plus points: The liberalization package is preceded by the minimum essential political setup: India's democratic form of society. In the transformation of economy into a highly efficient one, moving towards a market economy, India can benefit from her past experience of a mixed economy.
Indeed, this places India on a better footing vis-a-vis China, East Europe and other centrally planned economies. India has a very good track record of fulfilling international commitments, with a comparatively low debt service ratio compared to Latin American and some of the African countries.
India has a large supply of skilled manpower and cheap labour. India has a reasonably good basic infrastructure.
It is against this backdrop, that India's stabilization measures should be assessed. In the short run, it has fulfilled the specific stabilization objectives i.e., reducing the balance of payments and the budgetary gaps and recouping all the losses in the foreign exchange reserves.
However, a word of caution is needed, from the experience of other countries it has been observed that a short-term success in the stabilization phase often tempts policy-makers to sit back and prolong the phase of stabilization process. In a number of cases this has led to stagflation.
The continuance with too high a foreign reserve ratio (as in India) against a heavy import compression requires a warning. Indeed, a large part of the present problem is due to India's lack of proper foreign exchange reserve management.
This warning is specially needed when stabilization is achieved through soft option (import and expenditure compressions and heavy foreign exchange borrowings) regardless of the needs for growth and productivity (as observed in number of other countries).
This may retard and render difficult the desired transition to growth. To avoid this, the adjustment process could be slowed down if necessary, specially in certain areas of reform (for example, the rate of decline in the budget deficit as percentage of GDP). The therapeutic approach of a shock treatment in the reform process may not work in India.
As observed in the case of other countries, a structural adjustment process is much more complex than the stabilization process, and therefore should not be left only with the bureaucrats and politicians. There is no standard recipe for the structural adjustment phase, although there is a far degree of commonality in the stabilization phase.
In choosing proper sequencing a very strong financial and banking infrastructure is a pre-requisite to establishing appropriate market codes of conduct. Therefore financial liberalization should not be postponed for too long.
Moreover, in tune with the spirit of present economic reform, decisions on privatization and exit policy should follow early in the game. Although a high rate of inflation is a problem the key issue is to revamp the real growth of the economy by suitable investments and incentives.
In the context of improving productivity and international competitiveness, technology improvement should be the buzz word. The attempts to reduce the costs exclusively through fiscal. Monetary, financial and trade policies have their limits. Ultimately, it is the technological progress which matters.
Imports of technology via foreign direct investment should accordingly feature at the centre as a necessary condition for increasing efficiency. However, the absorption and indigenization of foreign technology alone will satisfy the requisite condition for success.
This will be made possible by the growth of research and development in the domestic economy. Reforms, therefore, the research and development policy, must provide a clear strategy and sufficient resources.
To conclude, when Liberalization reforms were initiated the economy was suffering with the heavy foreign exchange constraints and import compression and a relatively unfavorable international scenario but India will have to go through a painful prolonged period of adjustment.
Thus, the country must prepare itself to meet this challenge by first protecting the poor and second by protecting the infrastructure and human development needs.