Wisdom of the past
Heeding historical precedents, the Indian government must seek deeper integration with the global economy and work towards even more market-oriented reforms
At a time when India is undergoing a serious economic crisis and the Prime Minister, Narendra Modi is busy in consulting economists and the stakeholders to find out ways and means to overcome it, an ADB publication has come out with a suggestion that the country needs deeper integration with global economy and further reform in labour and land markets, national railways and the banking system to sustain high growth. It is particularly important in the context of the budget to be tabled within a fortnight in the Parliament of India for which preparations are going on full swing with focus on pushing forward the market-led economy and reforms.
While emphasising on the 'market-led economy' as the major factor for rapid economic development, the publication 'Asia's Journey to Prosperity' has traced the history of economic development in the country from the era of the Mughal Empire to the present age, especially the last 50 years, to explain the rise and fall of its economic growth. There are lessons to be learnt from this work as to how and why we have travelled to the present stage of economic conditions and also the prospects and risks ahead.
Tracing pre-independence industrial development, it says that India had well-developed traditional industries during the Mughal Empire (1526–1858). Economic historians estimate it produced about 25 per cent of world industrial output in 1750 and was a major contributor to global textile exports. However, a long-run decline began around 1750 due to (i) political instability and battles between competing groups as the Mughal empire began to weaken; (ii) massive imports of cheap factory-based textiles and other manufacturing goods from Europe, particularly the UK, in the 1800s.
The development of modern industries was slow under British rule (first through the East India Company from 1764 to 1857 and later through direct British government control from 1858 to 1947). An important reason was that British policy focused on using Indian resources to meet British needs rather than supporting indigenous industrial development, for example, by keeping tariffs low compared with other countries and discouraging Indian suppliers of manufacturing inputs. Nevertheless, there was some success in India's industrial development, led by a small group of merchants and traders. Industries included textiles, sugar, paper, cement, steel, shipbuilding and even some automobile production by the 1940s. Thus, in 1946, the share of modern manufacturing in national income was 8.7 per cent, compared with 1.9 per cent in 1900.
After independence in 1947, India used state-led industrialisation to accelerate economic growth, address widespread poverty and modernise the economy. The government chose key sectors to become state monopolies (for example, railways) and established exclusive rights to new investment in industries such as iron and steel, shipbuilding, mineral oils, coal, aircraft production and telecommunications, where new private investment was not allowed. While private firms were allowed in many other sectors, they faced regulatory requirements such as licensing (to guide the sector, location, and quantity of private investment) and import, foreign exchange, credit, and price controls.
The government established a planning agency to devise and implement five-year plans. Import controls included high tariffs, quotas and licensing. These were deemed necessary to develop a diversified industrial base and ensure scarce foreign exchange was used to import capital goods. Although the economy was under heavy state control with an inward-looking import substitution industrialisation strategy from the 1950s to the 1970s, state control changed in intensity over time. Policies in 1951–1965 were considered more liberal than afterwards. Investment licensing and import controls were less stringent until foreign exchange shortages grew serious. Some also considered the FDI regime relatively open during this period, as Prime Minister Jawaharlal Nehru saw the need for both foreign capital and technology.
But state control tightened from 1965 in response to a series of shocks and resulting economic problems. They included two years of serious drought, three wars with neighbours, a 1966 currency devaluation that largely failed and losses in some state elections by the dominant Congress Party. Prime Minister Indira Gandhi assumed office in 1966 and drove economic policy further toward state control with a greater focus on income redistribution. Measures included more stringent import licensing; nationalisation of banks, oil companies, and coal mines; restrictions on foreign companies and on the use of foreign exchange; restrictions on investment by large firms in sectors 'reserved' for small enterprises and barriers to laying off workers by firms with 300 or more employees (the 1976 threshold of 300 was further tightened to 100 in 1983).
India's state-led import substitution industrialisation strategy had mixed results. The economy expanded 4 per cent annually in the 1960s and 3.1 per cent in the 1970s. This was much better than the less than 1 per cent annual growth in the first half of the 20th century. However, in per capita terms, annual growth was just 1.8 per cent in the 1960s and 0.6 per cent in the 1970s, well below those in East Asia and Southeast Asia.
The weak economic performance in the 1960s and 1970s led some officials to begin advocating for relaxing state controls. Subsequently, in the second half of the 1970s and 1980s, successive governments attempted to introduce economic liberalisation, with each more significant than the preceding one. In industry, reforms mainly involved adjusting the existing industrial licensing system by reducing the number of industries covered. Similarly, in trade, measures were introduced to modify import licensing by reducing the number of import items banned or restricted. In the 1980s, several export incentives were introduced. Yet, despite these reforms, the essential economic management framework through licensing and controls remained until 1991, when India was hit by a balance of payments crisis.
Throughout the 1980s, India ran current account deficits. They grew particularly large during the second half of the decade, especially over the 3 years leading to the 1991 crisis. This was partly due to the steady growth of private investment and merchandise imports in response to liberalisation. At the same time, there was a rapid rise in central government spending, leading to a massive buildup of fiscal deficits, nearly 10 per cent of the GDP, on average, during 1985–1990. External debt increased rapidly and foreign exchange reserves dropped to just 1 month of imports in 1990–1991. As a result, India entered an IMF stand-by program in January 1991 with large financial support.
Yet, the situation continued to deteriorate. The Gulf War in 1990 resulted in an oil price hike and drop in remittances from the Middle East, worsening the balance of payments. In mid-1991, India's credit rating was downgraded, limiting the country's access to world financial markets. The government had to ask the IMF and the World Bank for further emergency assistance in July 1991.
The IMF stand-by programs and World Bank structural adjustment loan came with policy conditions. ADB financial sector policy-based loan and bilateral assistance followed. Many of the proposed policy reforms were in line with the emerging consensus among Indian policymakers at the time. Most significantly, the 1991 reform program under Prime Minister P. V. Narasimha Rao and Finance Minister Manmohan Singh (who later became Prime Minister) was a departure from the old licensing and control framework. India abolished industrial licensing subject to a negative list; ended public sector monopolies in many industries; initiated a policy of automatic approval of FDI up to 51 per cent ownership and significantly reduced import licensing. Over time, India also reduced tariffs on non-agricultural goods.
Since 1991, India has introduced more sweeping reforms, ranging from taxation to finance, telecommunications, electricity and transport. The competition was enhanced in finance through, for example, the entry of new private and foreign banks, interest rate deregulation and listing of almost all public sector banks. Monetising fiscal deficits ended in the late 1990s. The 2003 Fiscal Responsibility and Budget Management (FRBM) act strengthened fiscal discipline. One of the most prominent recent reforms was the introduction of a Goods and Services Tax in 2017 under the administration of Prime Minister Narendra Modi, replacing fragmented state taxes. India also streamlined business regulations, including those for starting a business, obtaining construction permits and electricity connections. In 2016, it passed an Insolvency Bankruptcy Code, unifying laws for insolvency and bankruptcy. These systematic reforms helped improve India's economic performance significantly. Annual per capita GDP growth rose to 4.7 per cent in 1991–2017 from about 2 per cent during the 1960s–1980s. Annual trade growth (including both exports and imports of goods and services) reached more than 11 per cent in 1991-2017, compared with 5 per cent-6 per cent in the 1960s-1980s. Average annual FDI inflows increased by 14 times between the 1990s and the 2010s. Accelerating economic growth also led to more rapid poverty reduction. From 1990 to 2015, India's extreme poverty rate at the USD 1.90-a-day international poverty line declined from 47.4 per cent to 13.4 per cent.
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