Economic Environment and

Policy

What is the course

about?
EEP-Antecedents to Economic Reform

The Focus

Provide an understanding of the emerging

economic and policy environment in India
The discussion essentially covers the post-reform
(1991) period
The antecedents of economic reform provide the
context to the policy analysis
Trace changes in different policy domains in the
post-1991 period and identify emerging policy
challenges
The coverage of policies is not comprehensive
enough!!
EEP-Antecedents to Economic Reform

Broad Approach

Indian situation analyzed in the context of

Begin with the analysis of the 1990-91 crisis to

explore earlier conditions and policy paradigms

Conceptual underpinnings of market and government

(regulatory) failures
Experience of East Asian economies (where feasible)

Identify key policy distortions in different policy domains

Discuss changes envisaged in each policy domain and the
associated issues and challenges

Explore through the course how these distortions

have been addressed in the post 1991 period and
how a few new ones may be emerging
EEP-Antecedents to Economic Reform

A Caveat

India is a complex economy, society and polity

The complexity is significantly higher as the nation is large
and diverse and went (going) through five transformations
simultaneously (Guha, 2011)

National (colony to an independent state)

Democratic (political participation of women, castes)
Industrial (movement away from agriculture)
Urbanization (villages to towns)
Social (rights of subordinate groups)

Most other economies went through these transformations

sequentially (US, Europe, China)
The course focuses largely on the economic dimensions
and therefore remains inadequate to provide a complete
picture
EEP-Antecedents to Economic Reform

Why Regulate?
Market Failures &
Regulation
Introducing Key Concepts and
Providing the Context for Policy
Intervention

EEP-Antecedents to Economic Reform

Why regulate and how?

Market failures (discussed in Economic Analysis)

need to be corrected through regulation and policy
intervention to enhance social welfare
Endowment failures (another type o market failure)
may also require state intervention
But there can be government and regulatory
failures as well resulting in a variety of distortions
Policy challenge: how to regulate to avoid both
kinds of failures?

EEP-Antecedents to Economic Reform

Market Failure Occurs if

Markets, especially future markets, do not exist

Imperfections in access to information

Information asymmetry
Imperfections in foresight about the future
Externalities - positive or negative (private and social
costs/benefits not equal)
Public goods no rivalry and exclusion in consumption (quasipublic goods). Issues of free riding, state supply and possibility of
exclusion (roads, education)

Economic agents do not behave competitively

Misuse market power

Create entry barriers

What about scale economies and natural monopoly situations?

Idea of contestability and its implications for regulation

In these circumstances, if markets are allowed to operate

freely, these will not result in efficient outcomes

Result: Under/over investment, lack of provision, non-competitive

prices
EEP-Antecedents to Economic Reform

Regulation: Response to
market failure or regulatory
Regulation a response to public (consumer?) demand in
capture?
the presence of market failures?

Regulation a response to industrys demand (capture of

legislators)?

Industry (regulated) captures the regulatory agency (capture of

regulators)
But some regulations not supported by industry. Why?

Both types of empirical situations exist

Industries regulated in the absence of market failures and firms

support/lobby for regulation. Why?

Regulation supplied in response to the demands of interest

groups acting to maximize utility/income (efficiency focus?)
Relative influence of interest groups (votes?) matters

What about information problems for the state?

EEP-Antecedents to Economic Reform

Endowment Failure Another

Type of Market Failure?

Conventional perspective is restrictive as

endowment failures can be critical
Efficiency (maximization of surplus) vs. equality

Extant distribution of endowments important but ignored

in neo-classical perspective
Who gets property rights? (Role of policy?)
Distribution of surplus between consumers and
producers important for policy (dynamic efficiency)

Market errors: commission & omission

Distort markets & perpetuate crisis

Make participation in markets disadvantageous for certain
sections through terms of trade shifts

Reduction in wage-food price ratio during droughts is often

accompanied by no or slow renewal
EEP-Antecedents to Economic Reform

A Different Perspective...

Market errors: commission & omission..

Not create conditions (endowments) that make market

transactions advantageous
Perpetuate regular deprivation due to absence/unequal
distribution of endowments

Imperfections in credit markets

Under-investment in schooling
Under-investment in infrastructure (mobility), health

Dynamic vs. static efficiency

Maximization of surpluses over time

Role of externalities investments in endowments and
incentives for savings and investment are important

Distribution of surplus
Endogenous growth theories emphasize on the role of
human capital in increasing returns to investment
EEP-Antecedents to Economic Reform

10

Market Failures and

Regulation: Current
Both government & market failures exist
Choice not between markets or intervention but quality of
Consensus
intervention: When, where and how to intervene?

Disciplining function of market competition useful for

learning and efficiency
Performance of markets can be improved through a variety
of regulations including appropriate legal and property right
systems

Government may lack capacity or coherence for

appropriate action

Fiscal pressures and informational problems

Organizational vacuum in the government often does not
provide the requisite autonomy & incentives
Regulatory capture possibilities exist
Competition among interest groups may vitiate policy
EEP-Antecedents to Economic Reform
choices

11

The Context of
Economic Reforms in
India
Short, Medium & Long Term Dimensions of
the Economic Crisis in 1991 and the Focus
of Structural Reform

EEP-Antecedents to Economic Reform

12

Immediate Manifestations of
the Crisis

Severe balance of payments (BoP) problems

Low forex reserves (only enough for two weeks)

Near bankruptcy to service external debt

High rates of inflation

13-14% Jan-Jun'91
In late 1980s inflation was high despite no external
shocks (unlike oil shock of 1979-81)

Inadequacy of food stock

Diverse explanations of the crisis but two stood

out and were acted upon

Liberalization of the 1980s, external shocks and financial

mismanagement were major contributors in the short
and medium term
The key problems related to long term policy distortions
which required structural reform
EEP-Antecedents to Economic Reform

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Short-term Dimensions of the

Crisis (1989-91)

Worsening BOP situation - Increase in

current account deficits due to

Lowering trade balance (Growth of imports

greater than that of exports in 1990-91)
Lower inflow of remittances (Invisibles)

Surpluses in invisible a/c inadequate to cover part of

trade account deficits which was the case earlier

Growing external debt service obligations

Due to reliance on short-term costlier external
commercial borrowing (ECBs) during the 1980s
Institutional credit was more important in earlier years

More expensive forex NRI deposits (which were

on the rise) also added to the interest burden
EEP-Antecedents to Economic Reform

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Short-Term Dimensions of
the Crisis (1989-91)...

BoP Pressures got intensified by

Gulf War (Fall in remittances, increase in oil prices, major

expense in rescue operations in the Gulf)
Widening fiscal deficits spilled into higher prices and imports
and a drain on forex reserves
Downgrading of India's credit rating

Short-Term ECBs (180 Days) became un-available to rollover

short-term debt due this down-grade

Decline in investors confidence led to an outflow of Nonresident Indian (NRI) deposits

Increase in rates of inflation after the Gulf crisis (>15% in
second half of 1991) compounded BoP problems
A 15% appreciation of rupee during 1979-81 which had
adverse impact on exports

Forex rate got corrected in 1986 but was probably too late
EEP-Antecedents to Economic Reform

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Medium-Term Dimensions
Developments in the 1980s

Patterns of Industrial Production

Impressive growth in industrial production (8.5%)

Growth of consumer durables faster than consumer nondurables and intermediates

Stagnancy in indigenous oil production also led to more POL

imports

Import intensity of these goods was high leading to forex outgo

Demand for oil, fertilizer and defense added to import needs

Oil shock of 1979-81 added to the adverse impact

Export orientation led to expansion of exports in importintensive areas leading to higher imports
Growth of Industrial production led by durables had a
narrow base with limited externalities

The rich constituted the `home market which was not

sustainable
EEP-Antecedents to Economic Reform

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Medium-Term Dimensions
Developments in the
1980s.
Fiscal Profligacy

High fiscal, revenue and monetized deficits led to

increases in money supply and inflation

Government reversed the policy of ensuring surplus in

revenue account to finance productive capital account
deficit

Capital a/c surplus covered revenue a/c deficits

Faster growth of revenue (consumption) expenditure than

capital expenditure (productive)

Deficits also spilled into BoP crisis

As a result capacities were not getting built up (inflationary)

Growth of defense expenditure

Significant growth of subsidies with an adverse impact on
public investment
Wage populism led to de-linking of wage from productivity
rapid wage increases in the 1980s
EEP-Antecedents to Economic Reform

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Medium-Term
Dimensions
Developments
in the
Financing
of deficits
Public
debt in relation to GDP (50% in 1988-89 for
1980s...

both states and Centre) grew rapidly especially in

1980s
The overall savings rate had stagnated in 1980s
The share of higher cost domestic borrowings like the
small savings, provident fund was on the rise
Public debt was also financed through higher external
debt, especially higher cost short-term commercial
borrowings (ECBs)

This resulted in higher debt service burden with

possibilities of a debt trap

As well as inflationary pressures

EEP-Antecedents to Economic Reform

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Long-Term Dimensions
Rethinking Development
Major long-term problem was a relatively low growth
Strategies

of national income (3.5 - 5%)

Inadequacy of savings for financing planned
investments - excessive reliance on budgetary
resources led to large deficits
Broadly, five types of problems are identified:

Relative neglect of agriculture and rural development that

inhibited the growth of home market
Development of inefficient, high cost, un-competitive
industrial structure
Serious infrastructure (transport, telecom, power, petroleum
products scarce) and human capital bottlenecks
Significant financial capital constraints
External shocks
EEP-Antecedents to Economic Reform

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How to correct these failures?

Argument for Reforms

Various policies contributed to these failures by

introducing micro-economic rigidities which
resulted in several distortions
If these rigidities did not exist performance would
have been better
Rigidities did not allow firms to make rational
choices
Policy reforms required to reduce/eliminate these
rigidities/policy induced distortions
Liberalization should be seen as a remedy for the
longer-term constraints to growth

This is a structural reform process while stabilization

programme focused on the short and medium term
dimensions
EEP-Antecedents to Economic Reform

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What were the

rigidities that
structural reforms
aim to correct?
A Summary
(These rigidities got built over the years
with the implementation of various policies.
Many policies (e.g., those relating to exit,
labour and agriculture) not included here.
EEP-Antecedents to Economic Reform

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Industrial Policy Based

Rigidities

Policy did not encourage competition and contributed to

inefficiencies through:

Bureaucratic determination of plant capacity, product mix and

location through licensing regime

Severe entry and exit barriers with licensing and other controls
(e.g., Monopoly Restrictive Trade Practices Act - MRTPA)
Rent-seeking through and lobbying for licenses for capacities and
scarce materials as their acquisition provided monopoly power

Trade in scarce materials became more lucrative than efficient

manufacturing (no contests, or stick)

Pronounced pro-labour stance restricted workforce rationalization

Subsidized ailing small scale industry (SSI)

Market forces more or less ignored (lack of contestability)

Employment vs. efficiency: politically employment concerns critical

Policy needs to enhance export contribution of SSI ignored

Inhibited economies of scale through licensing and reservation for

SSI (certain sectors reserved for the small firms)
EEP-Antecedents to Economic Reform

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THE INDUSTRIAL CONTROL SYSTEM

The establishment and operation of an industrial enterprise in India has required

approval from the Central Government at almost every step. Before making an
investment, an entrepreneur has to obtain approval in principle from the Ministry of
Industry. The granting of this approval results in the issuance of a Letter of Intent
(LOI). Armed with this LOI, the entrepreneur can then tie up other requirements for
setting up the project. If he needs to import a capital good, he must obtain a capital
goods import license from the Chief Controller of Imports & Exports (CCI&E), in the
Ministry of Commerce. The approval for the import, however, is given by a committee
set up in the Ministry of Industry. If there is also a need for a foreign collaboration
agreement, the entrepreneur has to obtain a specific approval for this, an F.C. approval,
from a committee chaired by the Finance Secretary, but serviced by the Ministry of
Industry. In order to raise funds for the project, if an entrepreneur wants to go to the
capital market, he needs separate approval from the Controller of Capital Issues in the
Ministry of Finance. For imports of raw material and components, separate licenses
have to be obtained on an annual basis from the CCI&E. In each case, an essentiality
and indigenous nonavailability clearance has to be given by the technical wing of the
Ministry of Industry, the Directorate General of Technical Development. Once
everything is tied up and the unit is about to go into production, the entrepreneur has to
go back to the Ministry of Industry for an Industrial License. (Mohan and Aggarwal,
1990)
EEP-Antecedents to Economic Reform

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Trade Policy Based

Rigidities
High import tariffs meant low imports based competition
An anti-export bias which blunted export rivalry and the
associated spillover benefits from exports
This bias was reinforced by

Curbed imports via tariffs and quantitative controls as a part of

import-substitution strategy. This led to reduction in external
competitive pressures and increases in input costs, especially of
exportables
Foreign exchange policy with over-valued rupee made Indian
exports non-competitive
Black (Hawala) market emerged (US $ 5 billion transactions
estimated for 1990) and capital flight took place (about Rs
2,60,000 crores stashed away by Indians in Swiss Banks!)

Rent seeking possibilities were high with multiple tariff rates,

quotas and complex exemptions

Inverted tariff structures (lower tariffs on final products and higher

tariffs on inputs) created biases against local production as well as
EEP-Antecedents to Economic Reform
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exports

Public Sector Policy Based

Rigidities

Pervasiveness of the public sector in heavy industry

and infrastructure

Reservation for the public sector created entry barriers

Inefficiencies in PSUs led to higher input costs with significant
adverse effects for the rest of the economy through a variety
of input-output linkages
Infrastructure bottlenecks were particularly severe

Inefficiencies along with soft budget constraints meant

low rates of return and no surpluses for reinvestment
Provided monopoly power to PSUs in industries which
were reserved

No incentives or pressures to be efficient

With significant trade barriers these inefficiencies got
transmitted to other firms and sectors (esp. non-tradables)
EEP-Antecedents to Economic Reform

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Foreign Investment Policy

Based Rigidities

Severe restrictions on portfolio and direct investment

Tight controls on technology transfer, licensing,

international marketing (brand) etc.

Sectors of entry as well as extent of equity controlled

No threat of potential foreign competition
Potential of technology flows through FDI restricted

License fees, royalty rates and sectors where foreign

technology can be licensed was controlled
Controls on foreign technology based entry by local producers
reduced these competitive pressures too

Internationally efficient scales of production could not

be achieved
EEP-Antecedents to Economic Reform

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Financial Sector Policy Based

Rigidities

Compared to industrial sickness, financial sector sickness has a

more severe impact through the multiplier effects, which are
more widespread for the latter
Capital constraints by "crowding out" of private sector and
diminished bank profits by

Administered interest rates (market forces ignored)

Directed "Policy Loans" to agriculture and small industry (~ 40%
of deposits) and government (SLR ~ 36% of deposits)
Bureaucrat determined pricing in securities market
The amount of money that could be raised from the equity market
was also decided by the government

Interestingly, many policies adopted by India were similar to

those used in East Asia but could not ensure contestability and
avoid rent seeking
The new economic policy (NEP) post 1991 was expected to
remove these and other micro-economic rigidities so that firms
could make rational choices (crisis was not only a short term
phenomenon, the roots lay in long term)
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