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Can Dr. Singh Cure his Economy?

By Arvind Panagariya

(September 21, 2004)

In May 2004, when India unexpectedly voted into power the Congress and its allies (later renamed the United Progressive Alliance) and Manmohan Singh became prime minister, it was a dream come true for proponents of economic reform. As finance minister in 1991, Mr. Singh-who meets President Bush today- had steered his country out of a major macroeconomic crisis. He went on to liberate the Indian economy from the stranglehold of the "license raj," with its myriad of controls on imports and investment. The measures he put in place in his five-year term delivered a handsome annual GDP growth of 7.5% from 1994-97 and 6% during the 1990s.

Four months into the UPA rule, prospects are less rosy. GDP growth, which had touched 8% in  2003-04, is set to decline to 6% this year. Inflation, at 3.4% in 2002-03 and 5.4% in 2003-04, has edged up to 7.5%. Until April, everyone was betting on the appreciation of the rupee. But it has depreciated more than 6% against the dollar since then, despite the sale of several billion dollars by the central bank. The stock index Sensex has declined 10% from its April peak.

 Some of this is results from events beyond Mr. Singh's control: The lower growth-rate projections are largely attributable to the expected decline in agricultural growth due to bad weather; and inflation has been fed by increased world prices of oil and metals, especially steel. But some of the scaling down of expectations is due to UPA policy. Pessimists are justifiably alarmed over two developments. First, having embraced the view that its election success owes much to the neglect of India's rural poor in the past decade, the UPA plans to increase expenditure substantially in agriculture, education and health. Second, the intensification of India's economic reforms is in doubt. The UPA has abandoned the privatization program that had finally gained some momentum under the BJP government and has ruled out labor-market reforms.

The view that the past reforms neglected the rural poor and agriculture is questionable. The '90s and early 2000s saw poverty decline in rural <CF401>and </CF>urban areas; and though public investment in agriculture declined, its adverse effect on farm incomes was more than offset by increased subsidies on agricultural inputs (electricity, irrigation, fertilizer) and price supports. Moreover, because the reforms concentrated on the liberalization of the industry, the terms of trade shifted in favor of agriculture, helping private investment grow faster than output in the sector.

A key priority of the government has to be to reduce the fiscal deficit. The combined deficit of the center, states and public enterprises in India has been in excess of 10% of GDP for the last several years. In addition, at 80% of GDP, India's public debt far exceeds that of many developing countries that experienced financial crises in the '90s. While India does not run the risk of an immediate financial outflow crisis due to its relatively closed capital account and a very large foreign exchange reserve in relation to its short-term liabilities abroad, the debt and persistent deficits can lead to higher inflation.  But the government is poised instead to add to the deficit by major increases in spending on agriculture and social sectors. These are unlikely to be matched by reduced spending on defense, subsidies or infrastructure as illustrated by the recent budget that raised military spending by as much as 19%. Nor is there likely to be a compensating increase in tax revenues: with trade reform, tariff revenues are likely to decline and the industry pressures have generally led to ever declining VAT rates without a commensurate expansion of the tax base. The estimates of higher revenue built into the recent budget have been widely questioned.

The prospect is therefore for accelerated inflation. As empirical studies underline, inflation has immediate adverse effect on the poor. And in so far as the government will then be inclined to spend yet more on agricultural relief, it runs the risk of feeding the inflation and becoming prisoner to a vicious cycle of spending and inflation. Also disconcerting is the UPA decision to step back from growth-enhancing reforms in critical areas. Reflecting coalition politics, where communist allies cannot be ignored, and also continuing intra-Congress tussles between old socialists and new reformers, the government has backed away from vigorous support for privatization. It has scrapped the Disinvestment Ministry, a major BJP innovation to advance the privatization program. It has also announced disapproval of privatization of public sector enterprises that are making profits, regardless of whether the profits are satisfactory.

There remains insufficient recognition of the need for clean-up in other areas if India is to achieve the announced target of 7% to 8% annual growth rate over the next five years. The growth rate in industry needs to improve: contrary to the experience in other countries, its share in the GDP has failed to grow even as the share of agriculture has declined. Despite an immense pool of unskilled labor and low wages, unskilled-labor-intensive industry has performed relatively poorly in India. India's export growth has accelerated in response to the opening up during the '90s but the fastest growing exports have been either capital-intensive (such as auto parts and machinery) or skilled-labor-intensive (pharmaceuticals and software). So industrial expansion has failed to create well-paying jobs for the unskilled and to reduce pressure on the farms.

The policy obstacles behind this sorry situation are widely known. First, a large number of the unskilled-labor-intensive products are reserved for small-scale enterprises. This has handicapped the growth of modern enterprises that can compete effectively abroad. It has also affected the inward flow of direct investment: Tyco will not produce toys in India if toy manufacturing is restricted to small enterprises. Second, under the labor laws, firms with 100+ workers are not permitted to lay off workers under any circumstances, deterring larger firms from manufacturing even products that are free from the small-scale-industries reservations.

By turning a blind eye to these ills, UPA invites economic failure. Mr. Singh is too good an economist and too accomplished a reformer not to appreciate the need for caution on expenditure and boldness on reform. The question is whether politics will force him into missteps. India's friends can only hope he will prevail.

 Mr. Panagariya is the Jagdish Bhagwati Professor of Indian Political Economy at Columbia.

 

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