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Country Study: India

Author(s):
Antonio Spilimbergo
Published Date:
June 2007
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Hélène Poirson

There can be little doubt that India is emerging as a global economic power: growth has accelerated; fiscal consolidation has reduced public indebtedness; and global integration has brought a number of benefits, including by helping to restrain inflation. Growth has also reduced poverty, and a prolonged economic takeoff could lift hundreds of millions more out of poverty. Significant constraints remain, however, including growing regional inequali ties; underdeveloped parts of the financial sector; and supply-side barriers, including massive infrastructure gaps. Progress made in addressing these challenges and the road ahead have been the main focus of recent IMF research.

India’s recent economic performance has been impressive. Growth has averaged 8½ percent over the last three years, placing it among the world’s fastest-growing economies. In contrast to much of Asia, growth has been led by domestic demand. Services and industry are driving the economy and have been growing at annual rates of 10 percent and 9 percent, respectively. Growth has been supported by an increase in investment and savings of 11 percentage points of GDP since 1998/99. From the supply side, India has experienced a surge in productivity, reminiscent of the 1980s, that Rodrik and Subramanian (2005) attributed to an “attitudinal shift in government” and India’s distance from its income-possibility frontier. The poverty rate has dropped from 26 percent in 1999–2000 to less than 22 percent in 2004–05.

Such success has elicited speculation among investors, academics, and policymakers on what the rise of India and China as economic powerhouses means for the world. Tseng and Cowen (2005) present an overview of research on the policy and institutional lessons to be learned from each country’s unique development path. More recently, Aziz, Dunaway, and Prasad (2006) focus on India and China’s financial sector and other pro-growth reforms, drawing lessons on how the two giants can support and learn from each other. A recent IMF book, India Goes Global: Its Expanding Role in the World Economy (Purfield and Schiff, eds., 2006) summarizes IMF research conducted during 2004–06 on the macroeconomic aspects of India’s emergence on the global stage.

India’s growth acceleration has coincided with a marked opening of its economy. More liberalized trade policies since 1991 have boosted export competitiveness. In addition, services exports—largely information technology (IT)—have boomed, thanks to the opening up to the private sector and foreign investment (Fernandez and Gupta, 2006). Trade liberalization appears to have reduced wage inequality by boosting the unskilled wage premium (Mishra and Kumar, 2005). As India gains market share in Asia, it is becoming a regional growth engine (Schiff, 2006; Lim, 2006). India is also reaping the benefits of higher foreign direct investment (FDI), which has increased in net terms from $0.1 billion in 1991/92 to $5.6 billion in 2005–06 and an estimated $11 billion in 2006–07. Sustained competitiveness, however, will require enhanced infrastructure, lower tariffs, and an improved business climate; the exchange rate is not an obvious bar, since there is no evidence that the rupee is misaligned at present (Purfield, 2006b). A related finding by Jain-Chandra (2006) is that difficulties of doing business, rather than the FDI regime (which is not overly restrictive by international standards), are limiting India’s FDI potential.

China’s World Trade Organization (WTO) accession and the recent lifting of quotas on textiles and clothing have made competitive challenges more pressing for India. Cerra, Rivera, and Saxena (2005) document the trade diversion from India owing to previous reductions in U.S. tariffs on Chinese imports. With the extent of third-party competition at only 25 percent of products and both countries specializing in different aspects of textile exports, however, they predict a relatively small decline in India’s market shares in the United States and the European Union; moreover, intermediate exports from India to China are likely to increase as China expands its exports of finished products, cushioning the economic welfare loss. Jain-Chandra and Prasad (2006) observe that following the lifting of quotas, India has gained market share in the United States, though less sharply than China owing to its rigid labor laws and deficient infrastructure.

Along with trade liberalization, gradual opening of the capital account has been a keystone of India’s success. Kohli and Wattleworth (2006) find that the opening to trade and capital have been mutually reinforcing. For instance, easing restrictions on external borrowing has increased trade by lowering corporate borrowing costs. Increased trade, in turn, has increased demand for the hedging and financial deepening that capital account liberalization can bring. India’s heavy reliance on more volatile portfolio and debt inflows has declined recently, with inflows shifting to more stable sources of financing. FDI inflows are poised to exceed portfolio inflows this year for the first time. India also remains one of the largest recipients of remittances in the world: these tend to be countercyclical and depend little on variables such as political uncertainty, interest rates, or exchange rates (Gupta, 2005).

As India continues its global integration, a healthy and vibrant financial sector is becoming a pillar of the country’s development strategy. Prasad and Ghosh (2005b) use annual data on scheduled commercial banks for 1996–2004 and find that competition in banking has increased since the inception of reforms in 1992. By studying the effect of monetary contraction on corporate borrowing from banks, Prasad and Ghosh (2005a) show evidence that the interest rate transmission channel has strengthened since 1998.

The authorities are now seeking a significant transformation of the Indian financial system, through pension and insurance reforms, and measures to develop the corporate debt and derivative markets. Poirson (2007) benchmarks India’s new pension plan against the experience of earlier emerging market reformers; the study finds that such reforms can be a significant factor in India’s financial market deepening, provided they build sufficient critical mass and the regulatory framework is not overly restrictive.

Recent growth in India has been accompanied by booming asset prices and credit, a welcome sign of financial deepening. Although such fast credit growth poses potential risks, the financial sector has become increasingly healthy. Despite recent rapid growth, the credit-to-GDP ratio and the public’s access to banking services remain low, and the banking system is dominated by less efficient public sector banks. Rozkhov (2006) highlights the need for more private ownership in the banking system—domestic as well as foreign—and addressing structural constraints to lending to small enterprises and agriculture. Purfield (2007) finds that rising asset prices largely reflect structural changes; targeted prudential measures are better tools than monetary policy to address potential risks, given the weak relationship between monetary policy and asset prices. Meanwhile, Sy (2005) shows evidence that public sector banks (and some old private banks) are more exposed to interest rate risk than foreign and new private banks; a key priority for the authorities will be to scrutinize the risk-management practices of individual banks.

Continued fiscal reforms are needed to channel savings to more productive uses. Consolidation efforts reduced the general government deficit from 10 percent in 2002/03 to an estimated 6 percent of GDP at the end of March 2007, while public debt declined from 86 percent to 79 percent of GDP during the same period. Drawing states into the adjustment effort by means of reforms in center-state relations was a keystone of the adjustment strategy, as analyzed in Purfield and Flanagan (2006). With the government’s spending needs unlikely to decline for some time, tax reform, examined in Flanagan (2006) and Poirson (2006), is essential to achieving a pro-growth consolidation. These papers lay out a strategy to generate revenues solely by broadening the tax base. In fact, lowering tax rates further could generate revenue via better compliance: Mishra, Subramanian, and Topalova (2006) estimate that the 67 percent reduction in average tariffs during 1988–2001 contributed nearly 90 percent of the decline in customs evasion.

Realizing India’s growth potential will require reforms to leverage the demographic dividend. Kochhar and others (2006) and Jaumotte and others (2006) have documented India’s idiosyncratic development pattern: India’s past growth has been driven by services, with a pool of engineers and scientists giving India an edge in higher-value-added activities. Within manufacturing, India has emphasized skill-intensive activities. With its working-age population expected to rise over the next 40 years, the country’s long-term growth prospects should receive a further boost. India needs to broaden its expansion to encompass labor-intensive manufacturing, however, including by tapping export markets, to realize this potential (Bosworth, Collins, and Virmani, 2006). Indeed, Purfield (2006a) finds that richer and faster-growing states are more effective at generating jobs and reducing poverty, which is resulting in growing regional inequality; other states, however, can catch up, if they make the right policy choices.

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