Routing

India is popularly viewed as having initiatedthe process of liberal reforms and the embrace ofoutward-oriented trade policies starting with theadoption of a major reforms package in July 1991.Subsequently, from 1992 to 2002, India’s grossdomestic product grew at the impressive annualrate of 6.1 percent. That rate contrasted with theso-called Hindu rate of growth of approximately3.5 percent during the first three decades ofIndia’s economic development. There was also asubstantial reduction in poverty during the 1990s.As such, observers have generally seen the Indianexperience during the 1990s and beyond as strongevidence that outward-oriented trade polices andpro-market reforms generated large benefits forthe people of that country.

A skeptical view has emerged recently, howev-er, which argues that the growth rate in Indiahad shifted in the 1980s, making it impossible tocredit reforms with the improved performanceof India. If those skeptics were right, it would bea major blow to liberal trade and market-friend-ly policies, not only with respect to India but todeveloping countries around the world. But a

closer look reveals that the story is more complexthan the skeptics would have us believe.

Three specific points emerge from a detailedanalysis. First, growth during the 1980s was patchy,with the last three years contributing 7.6 percentannual growth. Without those three years, growthin the 1980s would look, at best, marginally betterthan that of the previous three decades. Second, thehigh growth in the last three years of the 1980s was,in fact, preceded or accompanied by significant lib-eralization under Prime Minister Rajiv Gandhi,who had vowed to take India into the 21st centurywhen he first took office in 1984. Finally, growthwas stimulated partially by expansionary policiesthat involved accumulation of a large external debtand that ended in an economic crisis. In the end, itwas the 1991 market reforms and subsequent liber-alizing policy changes that helped sustain growth.

India can still do much to improve its eco-nomic performance. For example, India lagsbehind China largely because India’s relativelysmall industrial sector is hobbled, a problem thatmust be fixed through a further reduction in tar-iffs, privatizations, and other liberal measures.

The Triumph of India’s Market ReformsThe Record of the 1980s and 1990s

by Arvind Panagariya

_____________________________________________________________________________________________________

Arvind Panagariya is the Jagdish Bhagwati Professor of Indian Political Economy in the Department ofInternational and Public Affairs and Economics at Columbia University.

Executive Summary

No. 554 November 7, 2005

Introduction

Although public opinion in India contin-ues to move toward the view that liberalizationhas been good and should be ramped up, theview in some scholarly and policy circles hasturned skeptical. Some such observers nowargue that the average annual growth rate ofgross domestic product (GDP) had hit the 5.6percent mark in the 1980s, well before thelaunch of the July 1991 reforms. The growthrate in the 1990s was not much higher.Therefore, critics charge, liberalization cannotbe credited with having made a significant dif-ference to growth in India.1

This paper may seem narrowly focused onIndia’s path to greater wealth. But the debateabout Indian growth has implications for theoverall debate on globalization and theappropriateness of reforms in other develop-ing nations. A proper evaluation of theIndian case shows the key role that liberalreforms, including in trade and regulation,play in promoting and sustaining rapid eco-nomic development in poor countries.

Economic historian J. Bradford DeLongexpressed the skeptical view that

the acceleration of economic growthbegan earlier, in the early or mid-1980s,long before the exchange crisis of 1991and the shift of the government ofNarasimha Rao and Manmohan Singhtoward neoliberal economic reforms.

Thus apparently the policy changesin the mid- and late-1980s under thelast governments of the Nehru dynastywere sufficient to start the accelerationof growth, small as those policy reformsappear in retrospect. Would they havejust produced a short-lived flash in thepan—a decade or so of fast growth fol-lowed by a slowdown—in the absence ofthe further reforms of the 1990s? Myhunch is that the answer is yes. In theabsence of the second wave of reformsin the 1990s it is unlikely that the rapidgrowth of the second half of the 1980scould be sustained. But hard evidence to

support such a strong counterfactual judg-ment is lacking.2

Harvard University economist DaniRodrik carries DeLong’s skepticism to thenext level:

J. Bradford DeLong shows that the con-ventional account of India . . . is wrongin many ways. He documents thatgrowth took off not in the 1990s, but inthe 1980s. What seems to have set offgrowth were some relatively minorreforms. Under Rajiv Gandhi, the gov-ernment made some tentative moves toencourage capital-goods imports, relaxindustrial regulations, and rationalizethe tax system. The consequence was aneconomic boom incommensurate withthe modesty of the reforms. Further-more, DeLong’s back-of-the-envelopecalculations suggest that the signifi-cantly more ambitious reforms of the1990s actually had a smaller impact onIndia’s long-run growth path. DeLongspeculates that the change in officialattitudes in the 1980s, towards encour-aging rather than discouraging entre-preneurial activities and integrationinto the world economy, and a beliefthat the rules of the economic game hadchanged for good, may have had a big-ger impact on growth than any specificpolicy reforms.3

It is not entirely clear what policy message isto be gleaned from this skepticism. NeitherDeLong nor Rodrik suggests that the reformsof the 1990s were detrimental to the growthprocess. DeLong explicitly states that in theabsence of the second wave of reforms in the1990s, it is unlikely that the rapid growth ofthe second half of the 1980s could have beensustained. Rodrik is more tentative, emphasiz-ing the change in official attitudes over thechange in policies, possibly implying thatbecause the attitudes changed for good,growth would have been sustained even with-out the reforms of the 1990s.4 In this paper, I

2

The debate aboutIndian growth

has implicationsfor the overall

debate on globalization.

demonstrate that the skeptical view overstatesthe growth of the 1980s and understates thereforms of that time.

The Fragility of Growth in the 1980s

In comparing the performance prior to theJuly 1991 reforms with that following them,the conventional practice is to draw the line at1990–91 and thus divide the time period intothe decades of 1980s and 1990s. But, because1991–92 was the crisis year and the 1991reforms were a response to, rather than thecause of, the crisis, the conventional practicecreates a serious distortion. The July 1991reforms and subsequent changes could nothave begun to bear fruit prior to 1992–93. (SeeTable 1 for yearly growth rates from 1951 to2003.)

Therefore, for the purpose of this paper, Itake 1991–92 as the dividing line between thetwo periods. The period following the 1991reforms is defined as starting in 1992–93 andlasting through 2002–03, the 11-year periodfor which data are available. The pre-1991period precedes that time range, with thestarting date left vague at this point. Thoughit may be argued that the June 1991 crisis wasthe result of the policies of the pre-1991 peri-od and that, therefore, the year 1991–92 legit-imately belongs in it, where appropriate, Ipresent the analysis with and without thisyear included in the pre-1991 reform period.Throughout the paper, unless otherwise stated, theterms “1980s” and “1990s” refer to the pre- andpost-1991 reform periods as per the definitionsabove.

It is difficult to pinpoint the timing of theupward shift in India’s growth rate (seeFigure 1).5 Fortunately, however, two impor-

3

In 1988 anyonelooking back atthe 10-year experience wouldhave concludedthat India wasstill on the Hindugrowth path.

Table 1Annual Growth Rates of GDP, 1951–2003

Year Growth Rate Year Growth Rate Year Growth Rate

1951–52 2.3 1969–70 6.5 1987–88 3.81952–53 2.8 1970–71 5.0 1988–89 10.51953–54 6.1 1971–72 1.0 1989–90 6.71954–55 4.2 1972–73 –0.3 1990–91 5.61955–56 2.6 1973–74 4.6 1991–92 1.31956–57 5.7 1974–75 1.2 1992–93 5.11957–58 –1.2 1975–76 9.0 1993–94 5.91958–59 7.6 1976–77 1.2 1994–95 7.31959–60 2.2 1977–78 7.5 1995–96 7.31960–61 7.1 1978–79 5.5 1996–97 7.81961–62 3.1 1979–80 –5.2 1997–98 4.81962–63 2.1 1980–81 7.2 1998–99 6.51963–64 5.1 1981–82 6.0 1999–00 6.11964–65 7.6 1982–83 3.1 2000–01 (P) 4.41965–66 –3.7 1983–84 7.7 2001–02 (Q) 5.61966–67 1.0 1984–85 4.3 2002–03 (Q) 4.41967–68 8.1 1985–86 4.51968–69 2.6 1986–87 4.3

Note: P=Provisional Estimate; Q=Quick Estimate

Source: Author’s calculations based on Government of India, Economic Survey 2002–03, Table 1.2.

tant related facts remain valid regardless ofwhich starting date we choose. First, the years1988–91, during which the economy grew atthe high average annual rate of 7.6 percent,are critical to obtaining an average growthrate during the 1980s that is comparable to

the growth rate in 1990s. Second, the vari-ance of growth rates during the 1980s is sig-nificantly higher than that of the 1990s. Inthis sense, growth during the first period wasfragile relative to that in the second and,indeed, culminated in the June 1991 crisis.

4

Growth was morefragile in the

1980s than in the 1990s.

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1951–

52

1954–

55

1957–

58

1960–

61

1963–

64

1966–

67

1969–

70

1972–

73

1975–

76

1978–

79

1981–

82

1984–

85

1987–

88

1990–

91

1993–

94

1996–

97

1999–

00

GNPGDP

Figure 1Annual Growth Rates: GNP and GDP

Gro

wth

Rat

e

Year

Table 2Average Annual Growth Rates during Selected Periods

Period Growth Rate

Prior to the Shift in Growth Rate1951–52 to 1973–74 3.6

Pre-1991 Reform Period1981–82 to 1990–91 5.71981–82 to 1991–92 5.31977–78 to 1990–91 5.1

Memo1974–75 to 1978–79 4.91978–79 to 1987–88 4.11981–82 to 1987–88 4.81988–89 to 1990–91 7.6

Post-1991 Reform Period1992–93 to 2001–02 6.11992–93 to 2002–03 5.9

Source: Calculated from Table 1.

Table 2 offers the average growth rates forseveral selected periods. The average annualgrowth rate during the 11-year period from1992–93 to 2002–03 that I have defined as thepost–1991 reform period (the “1990s”) is 5.9percent. One obvious criterion for definingthe pre–1991 reform period (the “1980s”) is toselect 11 years from 1981–82 to 1991–92. Theaverage annual growth rate during that periodis 5.3 percent. If we remove the year 1991–92from the calculation, the average growth raterises to 5.7 percent.6 Either way, growth ratesbetween the 1980s and 1990s are comparable.

But consider the annual average growth ratesuntil 1987–88. For the 10-year period from1978–79 to 1987–88, the average growth rate isan unimpressive 4.1 percent. In 1988 anyonelooking back at the 10-year experience wouldhave concluded that India was still on the Hindugrowth path. Indeed, even limiting ourselves tothe period from 1981–82 to 1987–88, we get anaverage growth rate of only 4.8 percent, which isbelow the growth rate of 4.9 percent achievedduring the Fifth Five-Year Plan. Thus, had it notbeen for the unusually high growth rate of 7.6percent during 1988–91, we will not have the rea-son to debate whether the reforms of the 1990smade a significant contribution to growth. The

implication is that any explanation of growth inthe 1980s must explain the exceptionally highgrowth during 1988–91.

This discussion suggests that growth dur-ing the 1980s was subject to high variance.The point is also apparent in the data plottedin Figure 2. The growth path is visibly morevolatile in the 1980s than in the 1990s. Moreimportantly, we can test the hypothesis for-mally.7 The conclusion that growth was morefragile in the 1980s than in the 1990s is sup-ported unequivocally by the data.

What were the sources of the shift in thegrowth rate in the 1980s, especially the periodfrom 1988 to 1991? In the following sections, Iargue that two broad factors account for muchof the spurt. First, liberalization played a signif-icant role. On the external front, policy mea-sures such as import liberalization, exportincentives, and a more realistic real exchangerate contributed to productive efficiency. Onthe internal front, freeing up of several sectorsfrom investment licensing reinforced importliberalization and allowed faster industrialgrowth. Second, both external and internal bor-rowing allowed the government to maintainhigh levels of public expenditures and thusboost growth through demand. Unfortunately,

5

By the mid 1970s,industrialistsstarted pressingthe governmentfor the relaxationof controls.

1.2

9.0

1.2

7.26.0

3.1

7.7

4.34.54.33.8

10.5

6.75.6

1.3

5.15.9

7.37.37.86.56.1

4.45.6

4.4

7.5

5.5

-5.2

4.8

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1974–75 1977–78 1980–81 1983–84 1986–87 1989–90 1992–93 1995–96 1998–99 2001–02

Pre-1991 Reform Growth Post-1991 Reform Growth

Figure 2Yearly Growth Rates of GDP

Financial Year (April 1–March 31)

Gro

wth

Rat

e of

GD

P

these factors carried with them the seeds of theJune 1991 macroeconomic crisis that broughtthe economy to a grinding halt.8

Connection to Liberalization

To appreciate the role of liberalization instimulating growth in the 1980s, it is useful tobegin with a brief background on import con-trols in India. In their pioneering study, JagdishBhagwati and Padma Desai of ColumbiaUniversity provide the most comprehensiveand systematic documentation of the widesweep of the interventionist policies that hadcome to exist by the late 1960s.9 As they note,general controls on all imports and exports hadbeen present since 1940. After India’s indepen-dence in 1947, import controls were relaxedthrough the expansion of the Open GeneralLicensing10 list in a stop-go fashion, with theFirst Five Year Plan (1951–56) representing aperiod of “progressive liberalization.”11 But aforeign exchange crisis in 1956–57 put an endto this phase of liberalization, and comprehen-sive import controls were restored and main-tained until 1966. In June of that year, underpressure from the World Bank, India devaluedthe rupee from 4.7 rupees to 7.5 rupees per dol-lar. The 57.5 percent devaluation was accompa-nied by some liberalization of import licensingand cuts in import tariffs and export subsidiesfor approximately a year. But by 1968 intensedomestic reaction to the devaluation led Indiato turn inward with vengeance.12 Almost all lib-eralizing initiatives were reversed and importcontrols tightened. This regime was consolidat-ed and strengthened in the subsequent yearsand remained more or less intact until thebeginning of a period of phased liberalizationin the late 1970s.

According to economist Gary Pursell, theseverity of the controls was reflected in adecline in the proportion of non-oil and non-cereal imports from a low of 7 percent in1957–58 to the even lower level of 3 percent in1975–76.13 Since consumer goods imports hadbeen essentially banned, the incidence of thisdecline was principally borne by machinery,

raw material, and components. The impact onthe pattern of industrialization and efficiencywas visible. Pursell offers a description of thecosts to the economy:

During this period, import-substitutionpolicies were followed with little or noregard to costs. They resulted in anextremely diverse industrial structureand high degree of self-sufficiency, butmany industries had high productioncosts. In addition, there was a generalproblem of poor quality and technologi-cal backwardness, which beset even low-cost sectors with comparative advantagesuch as the textiles, garment, leathergoods, many light industries, and prima-ry industries such as cotton. . . . Althoughimport substitution reduced imports ofsubstitute products, this was replaced byincreased demand for imported capitalequipment and technology and for rawmaterials not domestically produced orin insufficient quantities. During the1960s and the first half of the 1970s, theformer demand was suppressed by exten-sive import substitution in the capitalgoods industries and attempts to indige-nize R&D. By about 1976, however, theresulting obsolescence of the capitalstock and technology of many industrieswas becoming apparent, and a steady lib-eralization of imports of capital equip-ment and of technology started soonafter.14

Two factors facilitated the emergence ofthe liberalization phase. First, as suggested inPursell’s quote above, by the mid 1970s,industrialists were beginning to find thestrict regime counterproductive and startedpressing the government for the relaxation ofcontrols. A domestic lobby in favor of liberal-ization of imports of raw materials andmachinery had come to exist. At the sametime, in the case of raw material and machin-ery imports that had no import substitutes,there was no counter lobby. Second, im-proved export performance and remittances

6

The pre-1991reforms were

introduced quietly and

without fanfare.

from overseas workers in the Middle East hadled to the accumulation of a comfortablelevel of foreign exchange reserves. Thesereserves lent confidence to policymakers andbureaucrats who had lived in the perpetualfear of a balance of payments crisis.

Against this background, consider succes-sively the reforms undertaken starting in thelate 1970s and their impact on the economy.

Reforms of the 1980sIn view of the continuing dominance of

leftist ideology in India, the pre-1991 reformswere introduced quietly and without fanfare.Therefore, the term “liberalization by stealth,”often used to describe them, is fully justified.Yet, this description gives the misleadingimpression that the reforms were marginal orinconsequential to the growth performance.As I will argue below, the reforms were deeperthan is generally appreciated and had a dis-tinct impact on the growth rate in the 1980s.

Although the relaxation of industrial regula-tion began in the early 1970s and trade liberal-ization began in the late 1970s, the pace ofreform picked up significantly only in 1985.Major changes were announced between 1985and 1988, with the process continuing to moveforward thereafter. Indeed, during the latterperiod, liberalization had begun to take a some-what activist form. In turn, GDP growth and theexternal sector registered a dramatic improve-ment in performance. As already noted, GDPgrew at an annual rate of 7.6 percent from1988–89 to 1990–91. Exports, which had grown

annually at a paltry rate of 1.2 percent during1980–85, registered a hefty annual growth of14.4 percent during 1985–90 (Table 3).

Broadly, the reforms of the 1980s, whichwere largely in place by early 1988, can bedivided into five categories. First, the OpenGeneral Licensing list was steadily expanded.Having disappeared earlier, the list was rein-troduced in 1976, with 79 capital goods itemson it. The number of capital goods items onthe list expanded steadily, reaching 1,007 byApril 1987, 1,170 by April 1988, and 1,329 byApril 1990. At the same time, intermediateinputs (used to produce other goods) wereplaced on the list, and their number expandedsteadily over the years. Based on the best avail-able information, this number had reached620 by April 1987 and increased to 949 inApril 1988. According to Pursell, “importsthat were neither canalized [monopoly rightsof the government for the imports of certainitems] nor subject to licensing (presumablymainly OGL imports) increased from about 5percent in 1980–81 to about 30 percent in1987–88.”15 The inclusion of an item into thelist was usually accompanied by an “exemp-tion,” which amounted to a tariff reductionon that item. In almost all cases, the items onthe list were machinery or raw materials forwhich no substitutes were produced at home.As such, their contribution to increased pro-ductivity was likely to be significant.

The second source of liberalization wasthe decline in the share of canalized imports.Between 1980–81 and 1986–87, the share of

7

Low or decliningbarriers to tradeconstitute a necessary condition for sustained rapidgrowth.

Table 3Average Annual Growth Rates of Non-Oil Merchandise Exports and Imports in CurrentDollars

Year Exports Imports

1970–71 to 1974–75 16.2 17.81975–76 to 1979–80 13.7 12.31980–81 to 1984–85 1.2 7.11985–86 to 1989–90 14.4 12.3

Source: Author’s calculations from the data in the Reserve Bank of India, Statistical Handbook, 2001 (Table 115). RBI

cites its source as the directorate general of commercial intelligence and statistics.

these imports in total imports declined from67 to 27 percent. Over the same period, canal-ized non-POL (petroleum, oil, and lubri-cants) imports declined from 44 to 11 per-cent of the total non-POL imports. Thischange significantly expanded the room forimports of machinery and raw materials byentrepreneurs.16

Third, several export incentives were intro-duced or expanded, especially after 1985,which helped expand imports directly whenimports were tied to exports and indirectly byrelaxing the foreign exchange constraint.Replenishment (REP) licenses, which weregiven to exporters and could be freely tradedon the market, directly helped relax the con-straints on some imports. Exporters weregiven REP licenses in amounts that wereapproximately twice their import needs and,thus, provided a source of input imports forgoods sold in the domestic market. The keydistinguishing feature of the REP licenses wasthat they allowed the holder to import itemson the restricted (and therefore those outsideof the OGL or canalized) list and had domes-tic import-competing counterparts. Eventhough there were limits to the import com-petition provided through these licenses, asexports expanded the volume of these im-ports expanded as well. This factor becameparticularly important during 1985–90, whenexports expanded rapidly.

In addition to a substantial widening of thecoverage of products available to exportersagainst replenishment licenses, Vijay Joshi andI. M. D. Little of Oxford University list the fol-lowing export incentives introduced between1985–86 and 1989–90, referring to them asthe “quasi-Southeast Asian style” reforms:

• In 1985, 50 percent of profits attribut-able to exports were made income-taxdeductible; in the 1988 budget that wasextended to 100 percent of export profits.

• The interest rate on export credit wasreduced from 12 to 9 percent.

• In October 1986 duty-free imports ofcapital goods were allowed in selectedexport industries. In April 1988 access

for exporters to imported capital goodswas increased.

• Exporters were assured that the incen-tives announced in the export-importpolicy would not be reduced for a periodof three years.17

The fourth source of liberalization was asignificant relaxation of industrial controlsand related reforms. Several steps are worthyof mention, including an increase in delicens-ing, tax reform, and abolition of some controlson price and distribution (see Appendix).

The relaxation of industrial controls rein-forced the ongoing import liberalization. Inthe presence of these controls, firms had tohave an investment license before they couldapproach the import-licensing authority formachinery and raw-material imports. Forproducts freed of industrial licensing, thislayer of restrictions was removed. Moreimportantly, under industrial licensing, evenfor products on the OGL list, machineryimports were limited by the approved invest-ment capacity and raw material imports bythe requirements implied by the productioncapacity. With the removal of licensing, thisconstraint was removed.

The final and perhaps the most importantsource of external liberalization was a realisticexchange rate. At least during the years ofrapid growth, there is strong evidence of nom-inal depreciation of the rupee correcting theovervaluation of the real exchange rate.According to Pursell, both the import-weight-ed and export-weighted real exchange ratesdepreciated steadily from 1974–75 to 1978–79with the approximate decline of the formerbeing 30 percent and of the latter 27 percent.18

This was also a period of rapid export expan-sion, as discussed below, and foreign exchangereserves accumulation that paved the way forimport liberalization subsequently. The years1977–79 also registered the healthy averageannual GDP growth of 6.5 percent. The realexchange rate appreciated marginally in thefollowing two years, stayed more or lessunchanged until 1984–85, and once againdepreciated steadily thereafter.

8

Although external debt was

helping the economy grow, itwas also moving

it steadily towarda crash.

Joshi and Little attribute a considerablepart of the success in export expansion duringthe second half of the 1980s to real exchangerate management. They observe that, startingin 1986–87, Indian exports grew considerablyfaster than world trade and as fast as theexports of comparable developing countries.19

Impact of the ReformsThe impact of reforms could be seen most

clearly on trade flows. Pursell states this suc-cinctly and emphatically: “The available dataon imports and import licensing are incom-plete, out of date, and often inconsistent.Nevertheless, whichever way they are manipu-lated, they confirm very substantial and steadyimport liberalization that occurred after1977–78 and during the 1980s.”20 He goes onto note that imports outside of canalization

and licensing (i.e., those mainly on the OGL)increased from 5 percent of total imports in1980–81 to 30 percent in 1987–88. The shareof non-POL imports increased from 8 percentto 37 percent over the same period.

Quite apart from this compositionalchange, there was considerable expansion ofthe level of imports during the 1970s and thesecond half of the 1980s. Increased growth inexports due to the steady depreciation of thereal exchange rate and remittances from theoverseas workers in the Middle East hadbegun to relax the balance of payments con-straint during the first half of the 1970s,leading to the expansion of non-oil importsat the annual rate of 17.8 percent (see Table3). That rapid expansion continued duringthe second half of the 1970s with non-oilimports registering an impressive 15 percent

9

Reforms of the1980s gave way tomore systematicand deeperreforms in the1990s andbeyond.

Table 4Merchandise Non-oil Exports and Imports as Percent of GDP

Year Non-Oil Exports as Percent of GDP Non-Oil Imports as Percent of GDP

1970–71 3.3 3.31971–72 3.3 3.31972–73 3.6 3.11973–74 3.8 3.71974–75 4.3 4.31975–76 4.8 4.91976–77 5.7 4.11977–78 5.3 4.41978–79 5.2 4.71979–80 5.3 4.91980–81 4.7 5.11981–82 4.5 5.01982–83 4.0 4.61983–84 3.7 5.01984–85 4.0 4.81985–86 3.7 5.31986–87 3.9 5.61987–88 4.2 5.11988–89 4.7 5.71989–90 5.5 6.0

Source: Calculated from data on exports, imports, GDP, and exchange rates in the Reserve Bank of India, Statistical

Handbook, 2001. RBI cites its source of the trade data as the directorate general of commercial intelligence and statistics.

annual growth rate over the 10-year periodspanning 1970–79. In contrast, in the subse-quent five years when the real exchange rateappreciated slightly and the income growthslowed down, non-oil imports expanded only7.1 percent per annum (Table 3). Again, dur-ing 1985–90, they grew 12.3 percent. Thus,liberalized licensing rules flexibly accommo-dated the increased demand for imports dur-ing the fast-growth periods.

Alternatively, the impact of liberalizationcan be seen in the movement in the imports-to-GDP ratio. Table 4 shows non-oil importsas a proportion of the GDP. In 1976–77, thisratio had bottomed out at 4.1 percent.Starting in 1977–78, fortuitously the year inwhich the real exchange rate depreciated sub-stantially, this ratio began to rise, reaching5.1 percent in 1980–81. In the subsequentyears, it showed a moderate downward trend,reaching 4.8 percent in 1984–85. In 1985–86,when the Rajiv Gandhi era reforms werekicked off, the ratio began to climb up steadi-ly again until it reached 6 percent in the year1989–90. This rise is especially importantsince GDP itself grew at a relatively high rateduring these years.

In an earlier paper, I have argued that lowor declining barriers to trade constitute anecessary condition for sustained rapidgrowth.21 From the discussion and evidenceabove, it should be clear that India’s experi-ence during the 1980s is no exception to thisproposition. We may quibble about the mag-nitude of trade and industrial liberalizationduring those years. But the fact is that theyears of high growth have also seen a reduc-tion in barriers to trade and a sizable expan-sion of non-oil exports and imports.

It is worth repeating that during the1980s India was helped by the discovery of oiland the spread of the Green Revolution,which freed up foreign exchange for non-oil,nonfood imports. At the same time, hadIndia not responded by opening up trade andinvestment rules, the opportunity offered bythose developments would have been lost.

The impact of reforms is also seen in high-er industrial growth. Discussing the changes

in domestic industrial policy, Ashok Desainotes, “The changes were complex and arbi-trary, but they led to an acceleration of indus-trial growth from 4.5 per cent in 1985–86 to apeak of 10.5 per cent in 1989–90.”22 The 9.2percent rate of industrial growth during1988–91 was particularly high compared withearlier periods.

According to B. N. Goldar and V. S.Renganathan, the import penetration ratio inthe capital goods sector rose from 11 percentin 1976–77 to 18 percent in 1985–86.23 Thattrend appears to have continued subsequently.R. N. Malhotra notes that the incrementalcapital-output ratio, which had reached ashigh as 6 at times, fell to approximately 4.5during the 1980s.24 These observations areconsistent with the finding by Joshi and Littlethat the productivity of investment increasedduring the 1980s, especially in private manu-facturing.25

Satish Chand and Kunal Sen of theAustralian National University have studiedthe relationship between trade liberalizationand productivity in manufacturing duringthe 1973–88 period.26 Table 5 presents theirfindings. According to their measure, andconsistent with my earlier discussion, protec-tion declines over the sample period in inter-mediate and capital goods sectors but notconsumer goods sector. Moreover, there is asignificant improvement in total factor pro-ductivity growth (TFPG) in all three sectorsin 1984–88 compared with the two earlierperiods. Thus, the jump in TFPG coincideswith the liberalization in capital and inter-mediate goods.

Chand and Sen do some further tests andshow that on average a 1 percent reduction inthe price wedge (the difference between theIndian and U.S. price) leads to 0.1 percent risein the total factor productivity.27 For theintermediate goods sector, the effect is twiceas large. The impact of the liberalization ofthe intermediate goods sector on productivi-ty turns out to be statistically significant inall of their regressions.

Joshi and Little also address the issue ofthe shift in the growth rate. They consider

10

Today, all but ahandful of goodscan be importedwithout a license

or other restrictions.

the years 1960–61 to 1989–90, dividing theminto a low-growth period (from 1960–61 to1975–76) and a high-growth period (from1976–77 to 1989–90). Average annual growthrates during these periods were 3.4 and 4.7percent, respectively.28 A key finding of Joshiand Little is that increased investment can-not be credited with the increase in thegrowth rate from 1976 to 1990 over thatfrom 1960 to 1976:

Public real investment averaged 7.7percent of GDP in the first period and9.9 percent in the second period.Private real investment averaged 12.0percent of GDP in the first period and11.7 percent in the second period.Thus the whole of the rise in the invest-ment level took place in the public sec-tor (ignoring errors and omissions).However, the rate of growth of publicsector GDP declined (from 7.8 to 7.2percent a year), while that of the privatesector rose (from 2.6 to 3.7 percent ayear).29

Joshi and Little attribute the shift in thegrowth rate to increased demand throughfiscal expansion, more efficient use of theexisting resources (due to liberalization), and

the rise in the real yield of investment in pri-vate manufacturing.30

Neither Joshi and Little nor Chand and Senseparately analyze the period 1988–91, whichis crucial to obtaining comparable growthrates between the 1980s and the 1990s. Itstands to reason that the results of Chand andSen would hold even more strongly for thisperiod. The reason is that average annualindustrial growth of 9.2 percent from 1988 to1991 was significantly higher than the 6.2 per-cent growth achieved from 1984 to 1988. Inview of the fact that private investment as aproportion of GDP did not rise, the substan-tially higher growth in industrial output islikely to be the result of increased productivityand therefore related to the 1980s reforms.

Unsustainable Borrowing

Although the importance of liberalizationof industry and trade for the shift in the GDPgrowth rate during 1980s can hardly bedenied, borrowing abroad and governmentexpenditures at home also played a role. Asnoted above, Joshi and Little have pointedout that during the 1980s the investment-to-GDP ratio rose exclusively in the public sec-tor while it fell in the private sector. At the

11

The 1990sreforms were alsoaccompanied bythe lifting ofexchange controls.

Table 5Changes in Protection and Total Factor Productivity Growth by Industry Classification(unweighted averages)

Industry Classification Consumer Goods Intermediate Goods Capital Goods

Protection (percent change)1974–78 4.5 0.4 -1.81979–83 -1.1 1.4 1.71984–88 -0.4 -5.4 -4.3

Total Factor Productivity Growth (percent)1974–78 -0.5 -1.2 -1.61979–83 -1.2 -3.1 -1.51984–88 5.1 4.8 3.7

Source: Satish Chand and Kunal Sen, “Trade Liberalization and Productivity Growth: Evidence from Indian

Manufacturing,” Review of Development Economics 6, no. 1 (2002).

same time, the growth rate of public sectoroutput actually fell. Therefore, it is difficultto argue that borrowing abroad contributedto a boost in the growth rate by boostinginvestment in the 1980s. Nevertheless, it like-ly helped raise the total GDP growth rate indi-rectly by contributing to the rise in thegrowth rate of private-sector output.

Thus, for example, the external borrowinghelped bridge the considerable gap betweenexports and imports. Despite faster growthin exports than imports in the second half ofthe 1980s (due to a sizable initial gap), theabsolute difference between imports andexports remained large. Based on the ReserveBank of India trade data on the balance ofpayments accounts, total imports-to-GDPratio exceeded the total exports-to-GDP ratioby 2.5 to 3 percentage points throughout the1980s.31 Accordingly, the higher level ofimports was financed partially throughexternal borrowing.

Although foreign borrowing made a positivecontribution to growth, it also led to a rapidaccumulation of foreign debt, which rose from$20.6 billion in 1980–81 to $64.4 billion in1989–90.32 The accumulation was especiallyrapid during the second half of the decade withlong-term borrowing rising from the annualaverage of $1.9 billion from 1980–81 to 1984–85to $3.5 billion from 1985–86 to 1989–2000.Moreover, “other” capital flows and errors andomissions turned from a large negative figure inthe first half of the decade into a positive figure,indicating an increase in the short-term borrow-ing in the latter period. The external-debt-to-GDP ratio rose from 17.7 percent in 1984–85 to24.5 percent in 1989–90. Over the same period,the debt-service ratio rose from 18 to 27 percent.

The growth in debt was also accompaniedby a rapid deterioration in the “quality” ofdebt between 1984–85 and 1989–90. Theshare of nonconcessional debt rose from 42to 54 percent. The average maturity of debtdeclined from 27 to 20 years. Thus, althoughexternal debt was helping the economy grow,it was also moving it steadily toward a crash.

A similar story was also evolving on theinternal front. While external borrowing helped

relieve some supply-side constraints, rising cur-rent domestic public expenditures provided thestimulus to demand, particularly in the servicessector. T. N. Srinivasan and Suresh Tendulkarassign much of the credit for the growth during1980s to this demand-side factor. Defensespending, interest payments, subsidies, and thehigher wages following the implementation ofthe Fourth Pay Commission recommendationsfueled these expenditures.33 Table 6 documentsthe magnitude of the expansion of current gov-ernment expenditures at the federal and statelevels combined during the second half of the1980s. During the first half of the 1980s, theseexpenditures averaged 18.6 percent. In the sec-ond half, they rose to average 23 percent withthe bulk of the expansion coming from defense,interest payments, and subsidies, of which theaverage rose from 7.9 to 11.2 percent of theGDP.

As with external borrowing, high currentexpenditures proved unsustainable. Theymanifest themselves in extremely large fiscaldeficits. As Table 6 shows, combined fiscaldeficits at the central and state levels, whichaveraged 8 percent in the first half of the 1980swent up to 10.1 percent in the second half.Continued large deficits led to a buildup ofvery substantial public debt with interest pay-ments accounting for a large proportion ofthe government revenues. They also inevitablyfed into the current account deficits, whichkept rising steadily until they reached 3.5 per-cent of GDP and 43.8 percent of exports in1990–91. The eventual outcome of thesedevelopments was the June 1991 crisis.

A Brief Look at the 1990s

The substantial yet half–hearted reforms ofthe 1980s gave way to more systematic anddeeper reforms in the 1990s and beyond. Until1991 restrictions were the rule and reformsconstituted their selective removal accordingto a “positive list” approach, meaning that anitem required a license unless it was on theOGL list. But starting with the July 1991 pack-age, the absence of restrictions became the

12

Since 1991, Indiahas also carried

out a substantialliberalization oftrade in services.

rule, with a “negative list” approach. Thismeant that unless an item was explicitly on arestricted list, it could be imported withoutthe license. While the move toward this newregime has been decidedly gradual, with theprocess still far from complete, the shift in thephilosophy is beyond doubt.

To appreciate the wider sweep of reformsin the post–1991 crisis period, consider indetail the reforms in just two key areas:industry and external trade.

Deregulation of IndustryWith a single stroke, the “Statement of

Industrial Policy, July 24, 1991,” frequentlycalled the New Industrial Policy, did awaywith investment licensing and myriad entryrestrictions on MRTP firms (firms that fellunder the Monopolies and Restrictive TradePractices Act). It also ended public-sectormonopoly in many sectors and initiated apolicy of automatic approval for foreigndirect investment up to 51 percent.

On licensing, the new policy explicitly stat-ed, “industrial licensing will henceforth be

abolished for all industries, except those spec-ified, irrespective of levels of investment.”Exception to this rule was granted to 18 indus-tries. True to the commitment in the policythat “government’s policy will be continuitywith change,” this list was trimmed subse-quently until it came to include only five sec-tors, with all of them having justification onhealth, safety, or environmental grounds.34

The 1991 policy statement also limited thepublic-sector monopoly to eight sectors select-ed on security and strategic grounds. All othersectors were opened to the private sector. Inthe subsequent years, the number of public-sector monopolies has been trimmed, and,today, only railway transportation and atomicenergy remain in that category.

The New Industrial Policy did away withentry restrictions on MRTP firms. Again, thepolicy was notable for its unequivocal renun-ciation of the past approach:

The pre–entry scrutiny of investmentdecisions by so–called MRTP companieswill no longer be required. Instead,

13

Within 10 yearsthe ratio of totalgoods-and-services trade toGDP rose from17.2 percent to30.6 percent.

Table 6Fiscal Indicators: 1980–81 to 1989–90 (as percentage of GDP)

1980–81 to 1985–86 to1984–85 1989–90

(avg.) 1985–86 1986–87 1987–88 1988–89 1989–90 1990–91 (avg.)

Revenue 18.1 19.5 20 20.1 19.6 20.9 19.5 20Current

expenditure 18.6 21.4 22.6 23.1 22.7 24.8 23.9 23Defense 2.7 3.3 3.8 4 3.8 3.6 – 3.7Interest 2.6 3.3 3.6 4 4.2 4.6 4.8 3.9Subsidies* 2.6 3.3 3.4 3.5 3.6 4.2 – 3.6Capital

expenditure 7.5 7.4 8.3 7 6.3 6.5 6 7.1Total

expenditure 26.1 28.8 30.9 30.1 29 31.3 29.9 30.1Fiscal deficit 8 9.3 10.9 10 9.4 10.4 10.4 10.1

*CSO estimates.

Source: Government of India, Ministry of Finance (various issues), Indian Economic Statistics––Public Finance. Cited

in Vijay Joshi and I. M. D. Little, India: Macroeconomic and Political Economy: 1961–91 (Washington: World Bank,

1994).

emphasis will be on controlling and reg-ulating monopolistic, restrictive andunfair trade practices rather than mak-ing it necessary for the monopoly houseto obtain prior approval of Central Gov-ernment for expansion, establishment ofnew undertakings, merger, amalgama-tion and takeover and appointment ofcertain directors. . . . The MRTP Act willbe restructured . . . The provisions relat-ing to merger, amalgamation, and take-over will also be repealed. Similarly, theprovisions regarding restrictions onacquisition of and transfer of shares willbe appropriately incorporated in theCompanies Act.35

Those changes are now in place.In the area of foreign investment, the pol-

icy statement abolished the threshold of 40percent on foreign equity investment. Theconcept of automatic approval was intro-duced whereby the Reserve Bank of India wasempowered to approve equity investment upto 51 percent in 34 industries. In subsequentyears, this policy was considerably liberalizedwith automatic approval made available toalmost all industries except those subject topublic-sector monopoly and industriallicensing. In the 48 industries that accountfor the bulk of India’s manufacturing out-put, the ceiling for approval under the auto-matic route is 51 percent. In eight categories,including mining services, electricity genera-tion and transmission, and construction ofroads, bridges, ports, harbors, and runways,the automatic approval route is available forequity investments of up to 74 percent. Theautomatic approval of foreign direct invest-ment up to 100 percent is given in all manu-facturing activities in Special EconomicZones, except those subject to licensing orpublic-sector monopoly. Subject to licensing,defense is now open to the private sector for100 percent investment, with FDI (also sub-ject to licensing) up to 26 percent permitted.

External TradeAs mentioned, the July 1991 package made

a break from the 1980s approach of selectiveliberalization on the external trade front byreplacing the positive list approach with a neg-ative list approach. It also addressed tariffreform in a more systematic manner insteadof relying on selective exemptions on statuto-ry tariffs. In subsequent years, liberalizationwas extended to trade in services as well.

Merchandise Trade Liberalization The July 1991 reforms did away with

import licensing on virtually all intermediateinputs and capital goods. But consumergoods, accounting for approximately 30 per-cent of the tariff lines, remained under licens-ing. It was only after a successful challenge byIndia’s trading partners in the DisputeSettlement Body of the World Trade Organi-zation that those goods were freed of licensinga decade later, starting on April 1, 2001. Today,all but a handful of goods disallowed on envi-ronmental, health, and safety grounds and afew others that are canalized, such as fertilizer,cereals, edible oils, and petroleum products,can be imported without a license or otherrestrictions.

Tariff rates in India had been raised sub-stantially during the 1980s to turn quota rentsinto tariff revenue for the government. Forexample, according to the Government ofIndia, tariff revenue as a proportion of importswent up from 20 percent in 1980–81 to 44 per-cent in 1989–90.36 Likewise, according to theWTO, in 1990–91, the highest tariff rate stoodat 355 percent, the simple average of all tariffrates at 113 percent, and the import–weightedaverage of tariff rates at 87 percent.37 With theremoval of licensing, those tariff rates becameeffective restrictions on imports. Therefore, amajor task of the reforms in the 1990s andbeyond has been to lower tariffs. That has beendone in a gradual fashion by compressing thetop tariff rate while rationalizing the tariffstructure through a reduction in the numberof tariff bands. The top rate fell to 85 percent in1993–94 and 50 percent in 1995–96. Althoughthere were some reversals along the way (in theform of new special duties and unification of alow and high tariff rate to the latter), the gen-

14

The most disappointing

aspect of the1990s experience

has been a lack ofacceleration of

growth in theindustrial sector.

eral direction has been toward liberalization,with the top rate coming down to 25 percent in2003–04.

The 1990s reforms were also accompaniedby the lifting of exchange controls that hadserved as an extra layer of restrictions onimports. As a part of the 1991 reform, the gov-ernment devalued the rupee by 22 percentagainst the dollar, from 21.2 rupees to 25.8rupees per dollar. In February 1992, a dualexchange rate system was introduced, whichallowed exporters to sell 60 percent of theirforeign exchange in the free market and 40percent to the government at the lower officialprice. Importers were authorized to purchaseforeign exchange in the open market at thehigher price, effectively ending the exchangecontrol. Within a year of establishing this mar-ket exchange rate, the official exchange ratewas unified with it. Starting in February 1994,many current account transactions includingall current business transactions, education,medical expenses and foreign travel were per-mitted at the market exchange rate. Thosesteps culminated in India accepting theInternational Monetary Fund’s Article VIIIobligations, which made the rupee officiallyconvertible on the current account. Theexchange rate has been kept flexible (thoughnot freely floating) and has been allowed todepreciate as necessary to maintain competi-tiveness. It currently stands at approximately45 rupees per dollar.

Liberalization of Trade in ServicesSince 1991 India has also carried out a sub-

stantial liberalization of trade in services.Traditionally, services sectors have been subjectto heavy government intervention. Public-sec-tor presence has been conspicuous in the keysectors of insurance, banking and telecommu-nications. Nevertheless, considerable progresshas been made toward opening the door widerto private sector participation including for-eign investors.

Until recently, insurance was a statemonopoly. On December 7, 1999, the IndianParliament passed the Insurance Regulatoryand Development Authority Bill, which

established that agency and opened the doorto private entry, including foreign investors.Up to 26 percent foreign investment, subjectto licensing by the IRDA, is permitted.

Though the public sector dominates inbanking, private banks are permitted to oper-ate, with up to 74 percent foreign directinvestment (FDI) allowed. More than 25 for-eign banks and approximately 150 foreignbank branches are now in operation. Underthe 1997 WTO Financial Services Agreement,India committed to permitting 12 new for-eign bank branches annually.

The telecommunications sector has beenmuch more open to the private sector, includ-ing foreign investors. Until early 1990s, the sec-tor was a state monopoly. The 1994 NationalTelecommunications Policy provided for open-ing cellular as well as basic and value–addedtelephone services to the private sector, includ-ing foreign investors. Rapid changes in technol-ogy led to the adoption of the New TelecomPolicy in 1999, which provides the current poli-cy framework. Accordingly, FDI is limited to 49percent in most areas. Up to 100 percent FDI isallowed with some conditions for certainInternet service providers.

The government permits FDI up to 100percent in e–commerce. Automatic approvalis available for foreign equity in software andalmost all areas of electronics. The govern-ment permits 100 percent FDI in informa-tion technology units set up exclusively forexports. Up to 100 percent FDI is permittedin the infrastructure sector, including con-struction and maintenance of roads, high-ways, bridges, tunnels, harbors, and airports.

Since 1991 there have been several unsuc-cessful attempts to bring the private sector,including FDI, into the power sector. Themost recent attempt, the Electricity Bill of2003, replaces the power legislations dated1910, 1948, and 1998. The bill offers a com-prehensive framework for restructuring thepower sector and builds on the experience inthe telecommunications sector. It attemptsto introduce private-sector entry alongsidepublic–sector entities in generation, trans-mission, and distribution.

15

The response ofthe economy tothe reforms hasbeen an order ofmagnitude weaker in Indiathan in China.

Impact of LiberalizationTrade liberalization had a much more visi-

ble effect on external trade in the 1990s than itdid in the 1980s. The ratio of total exports ofgoods and services to GDP in India approxi-mately doubled from 7.3 percent in 1990 to 14percent in 2000. The rise was less dramatic onthe import side because increased external bor-rowing was still financing a large proportion ofimports in 1990, unlike in 2000. But the risewas still significant, from 9.9 percent in 1990to 16.6 percent in 2000. Within 10 years theratio of total goods-and-services trade to GDProse from 17.2 percent to 30.6 percent.

Liberalization also had a significant effecton growth in some of the key service sectors.Overall, the average annual growth rate in theservice sector shifted from 6.9 percent during1981–91 to 8.1 percent during 1991–2001. AsPoonam Gupta and Jim Gordon of the Inter-national Monetary Fund document, thatgrowth was largely the result of fast growth incommunication, financial, business, and com-munity services.38 Given substantial deregula-tion and opening up to private participation inat least the first three of those sectors, the linkof this acceleration to reforms can hardly bedenied.

The most disappointing aspect of the 1990sexperience, however, has been a lack of acceler-ation of growth in the industrial sector. Theaverage annual rate of growth in this sector was6.8 percent during 1981–91 and 6.4 percentduring 1991–2001. Given that many of thereforms were aimed at that sector, the outcomeis somewhat disappointing. There are at leastthree reasons for that poor performance. First,because of draconian labor laws, industry inIndia is increasingly outsourcing many of itsactivities so that growth in industry is actuallybeing counted as growth in services. Second,because of constraints in the areas of labor,small–scale industry, and power, large–scalefirms are still unable or unwilling to enter themarket. Finally, large fiscal deficits continue tocrowd out private investment.

Industry’s lackluster performance is theprincipal cause for the marginal accelerationof the growth rate in the post–1991 reform

era. The only way India can push its growthrate to the levels experienced by China in thelast two decades is by freeing conventionalindustry of several ongoing restraints.

Looking Ahead: Why India Lags behind China

The response of the economy to thereforms has been an order of magnitude weak-er in India than in China. Exports of goodsand services grew at annual rates of 12.9 and15.2 percent during the 1980s and 1990srespectively in China. Imports exhibited a sim-ilar performance. Consequently, China’s totaltrade to GDP ratio rose from 18.9 percent in1980 to 34 percent in 1990 and to 49.3 percentin 2000. The response to reforms in India hasbeen considerably weaker.

On the foreign investment front, differ-ences are even starker. FDI into China hasrisen from $.06 billion in 1980 to $3.49 bil-lion in 1990 and then to a whopping $42.10billion in 2000. China was slower to open itsmarket to portfolio investment, but once itdid, inflows quickly surpassed those intoIndia, reaching $7.8 billion in 2000. Evenallowing for an upward bias in the figures assuggested by some China specialists anddownward bias in the figures for India, thereis little doubt that foreign investment flowsinto China are several times those into India.

Although some differences between theperformances of India and China can beattributed to the Chinese entrepreneurs inHong Kong and Taiwan, who have been eagerto escape rising wages in their respective homeeconomies by moving to China, a more centralexplanation lies in the differences between thecompositions of GDPs in the two countries.Among developing countries, India is uniquein having a very large share of its GDP in themostly informal part of the services sector.Whereas in other countries a decline in theshare of agriculture in GDP has been accom-panied by a substantial expansion of industryin the early stages of development, in Indiathis has not happened. For example, in 1980,

16

Among developing

countries, India isunique in havinga very large shareof its GDP in themostly informal

part of the services sector.

the proportion of GDP originating in indus-try was already 48.5 percent in China, whereasin India it was only 24.2 (see Table 7). Services,on the other hand, contributed only 21.4 per-cent to GDP in China but as much as 37.2 per-cent in India.

In the succeeding 20 years, despite consider-able growth, the share of industry did not rise inIndia. Instead, the entire decline in the share ofagriculture was absorbed by services. Though asimilar process was observed in China, the shareof industry in GDP was already quite highthere. As a result, even in 2000, the share of ser-vices in GDP was 33.2 percent in China com-pared with 48.2 percent in India.

Why does this matter? Because typically,under liberal trade policies, developing coun-tries are much more likely to be able toexpand exports and imports if a large pro-portion of their output originates in indus-try. Not only is the scope for expandinglabor-intensive manufactures greater, a largerindustrial sector also requires importedinputs, thereby offering greater scope for theexpansion of imports. In India, the responseof imports has been just as muted as that ofexports. This is demonstrated by the fact thatthe Reserve Bank of India has had to pur-chase huge amounts of foreign exchange tokeep the rupee from appreciating in recentyears. And even then, it was unsuccessful and

had to let the currency appreciate 5 to 7 per-cent in nominal terms. Imports have simplyfailed to absorb the foreign exchange gener-ated by even modest foreign investmentflows and remittances.

The same factor is also behind the relative-ly modest response of FDI to liberal policies.Investment in industry, whether domestic orforeign, has been sluggish. Foreign investorshave been hesitant to invest in industry formany of the same reasons as domestic inves-tors. At the same time, the capacity of the for-mal services sector to absorb foreign invest-ment is limited. The information technologysector has shown promise, but its base is stillsmall. Moreover, this sector is more intensivein skilled labor than physical capital.

Therefore, the solution to both trade andFDI expansion in India lies in stimulatinggrowth in industry. The necessary steps arenow common knowledge: bring all tariffsdown to 10 percent or less, abolish the small-scale industries reservation, institute an exitpolicy and bankruptcy laws, and privatize allpublic-sector undertakings.

Conclusion

The Indian growth spurt prior to 1991 wasfragile and volatile. There was a jump in the

17

Foreign investorshave been hesitant to investin industry formany of the same reasons as domesticinvestors.

Table 7Composition of GDP (percent)

1980 1990 2000

ChinaAgriculture 30.1 27 15.9Industry 48.5 41.6 50.9Manufacturing 40.5 32.9 34.5Services 21.4 31.3 33.2

IndiaAgriculture 38.6 31.3 24.9Industry 24.2 27.6 26.9Manufacturing 16.3 17.2 15.8Services 37.2 41.1 48.2

Source: World Bank, basic indicators.

growth rate during 1977–79, massive declinein 1979–80, a jump again in 1980–82, returnto the Hindu rate during 1982–88 (except1983–84), a climb up again in 1988–91 andcrisis in 1991–92. This volatility in the growthpattern raises doubts about the sustainabilityof a 5 percent plus growth rate over the longhaul. The 1991 crisis only confirmed the fun-damental weakness of the underlying forcesex post.

In contrast, growth during 1990s has beenmore robust, exhibiting far less volatility.Whereas in the late 1980s, many observers ofIndia were betting on a crisis any time, there arefew takers of such a bet today. Despitewell–known vulnerabilities resulting from fis-cal deficits that are as large today as in the late1980s and the slow pace of banking reforms,few pundits are predicting an external crisistoday. The external–debt–to–GDP ratio hasbeen declining and foreign exchange reservesat approximately $120 billion exceed the cur-rency in circulation. Indeed, in a recent carefulexamination of India’s vulnerability to externalcrises, economist Montek Ahluwalia points toseveral key weaknesses in fiscal and bankingareas and emphasizes the urgency of tacklingthem. But he stops well short of predicting acrisis because, unlike in the 1980s, the externaldebt is low and declining, short–term debt is atiny proportion of the total external debt, andthe foreign exchange reserves are very substan-tial.39

The acceleration of growth during the1980s relative to that in the preceding threedecades was not achieved without importantpolicy changes. In contrast to the isolated adhoc policy measures taken to release immedi-ate pressures prior to the 1980s, the measuresin the last half of the 1980s, taken as a whole,constituted a significant change and anactivist reform program. For example, by1990, approximately 20 percent of the tarifflines and 30 percent of the imports had comeunder OGL, with significant exemptions ontariffs accruing to the OGL products. Import

licensing on many other products was alsoeased up considerably.40

The 1980s reforms and their success provid-ed crucial firsthand evidence to policymakersthat gradual liberalization can deliver fastergrowth without causing disruption. In turn,this evidence gave policymakers confidence inundertaking the bolder and more far-reachingreforms in the 1990s. While the changes in the1980s were undoubtedly small in relation tothose in the 1990s, they were quite significantwhen compared with the regime prevailinguntil the 1970s. In part, this fact explains whythe economy, particularly industrial growth,exhibited such a strong response. A key messageof the theory of distortions is that the larger theinitial distortion, the greater the benefit fromits relaxation at the margin. Therefore, the largeresponse to limited reforms is quite consistentwith at least the static theory of distortions.41 Inthis respect, DeLong’s observation that the elas-ticity of growth to reforms was higher in the1980s than in the 1990s is not altogether incon-sistent with theory, though it must be acknowl-edged that the response would have been short-lived in the absence of more concerted reforms.

DeLong’s contention that we lack hard evi-dence to support the view that the rapidgrowth of the second half of the 1980s couldnot be sustained without the second wave ofreforms in the 1990s is untenable. Thepre–1991 growth was itself fragile and spo-radic. And even then, it ended in a balance ofpayments crisis. The scenario of the secondhalf of the 1980s involving large amounts ofexternal borrowing could not have been sus-tained. Absent that, more substantial reformsthat improved efficiency, brought foreigninvestment to the country, and allowed sectorssuch as information technology to grow con-stituted the only way to avoid the return to theHindu rate of growth of the first 30 years ofindependence. For India and developing coun-tries around the world, the Indian experienceconfirms the importance of liberal reforms tosustained high growth.

18

The 1980sreforms providedcrucial firsthand

evidence that gradual

liberalization candeliver faster

growth withoutcausing

disruption.

Appendix: The Relaxation of Industrial

Controls and Related Reforms in the 1980s

• De–licensing received a major boost in1985, with 25 industries de–licensed (ofthese, 16 industries had been out of thelicensing net since November 1975). By1990 this number reached 31. The invest-ment limit below which no industriallicense would be required was raised to Rs.500 million in backward areas and Rs. 150million elsewhere, provided the invest-ments were located in both cases at stipu-lated minimum distances from urbanareas of stipulated sizes. Traditionally, theindustrial licensing system had applied toall firms with fixed capital in excess of 3.5million rupees. There remained 27 majorindustries subject to licensing regardless ofthe size and location of investment. Theseincluded a number of major industries likecoal, large textile units using power, motorvehicles, sugar, steel, and a large number ofchemicals. Products subject to Small ScaleIndustries (SSI) reservation were also offlimits, though the asset ceiling of firmsdesignated as SSI units was raised from Rs.2 million to Rs. 3.5 million.

• Broad banding, which allowed firms toswitch production between similar pro-duction lines such as trucks and cars, wasintroduced in January 1986 in 28 indus-try groups. This provision was signifi-cantly expanded in the subsequent yearsand led to increased flexibility in manyindustries. In some industries, the impactwas marginal, however, since a largenumber of separate product categoriesremained due to continued industriallicensing in those products.

• In 1986 firms that reached 80 percentcapacity utilization in any of the five yearspreceding 1985 were assured authoriza-tion to expand capacity up to 133 percentof the maximum capacity utilization

reached in those years. • Firms that came under the purview of

the Monopolies and Restrictive TradePractices Act were subject to differentrules could not take advantage of theabove liberalizing policy changes. Torelax the hold of the licensing and capac-ity constraints on these larger firms, in1985–86, the asset limit above whichfirms were subject to MRTP regulationswas raised from Rs. 200 million to Rs.1,000 million. As a result, as many as 90out of 180 large business houses regis-tered under the MRTP Act were freedfrom restrictions on growth in estab-lished product lines. Requirement ofMRTP clearances for 27 industries waswaived altogether. MRTP firms in a num-ber of industries were exempt fromindustrial licensing provided they werelocated 100 kilometers away from largecities. MRTP firms were allowed to availthemselves of the general de–licensingmeasures in which they were not consid-ered dominant undertakings. These mea-sures significantly enhanced the freedomof large firms (with assets exceeding Rs.1,000 million) to enter new products.

• Price and distribution controls on cementand aluminum were entirely abolished.Decontrol in cement eliminated the blackmarket and through expanded produc-tion brought the free–market price downto the controlled levels within a shorttime. New entrants intensified competi-tion, which led to improvements in quali-ty along with the decline in the price.

• There was a major reform of the tax sys-tem. The multi–point excise duties wereconverted into a modified value–added(MODVAT) tax, which enabled manufac-turers to deduct excise paid on domesti-cally produced inputs and countervailingduties paid on imported inputs from theirexcise obligations on output. By 1990MODVAT came to cover all subsectors ofmanufacturing except petroleum prod-ucts, textiles, and tobacco. This change sig-nificantly reduced the taxation of inputs

19

and the associated distortion. In parallel, amore smoothly graduated schedule ofexcise tax concessions for SSI firms wasintroduced, which reduced incentives forthem to stay small.

NotesThis paper is based on International MonetaryFund Working Paper no. 04/43. I am grateful toJagdish Bhagwati, Kalpana Kochhar, and T. N.Srinivasan for their helpful comments. I also thankRajesh Chadha, Satish Chand, Douglas Irwin,Raghav Jha, Vijay Joshi, Vijay Kelkar, Ashoka Mody,Sam Ouliaris, Jairam Ramesh, Jayanta Roy, RatnaSahay, Kunal Sen, N. K. Singh, Ian Vásquez, andRoberto Zagha for their helpful suggestions onearlier drafts of this paper.

1. Many opponents of reform in the political arena,including some in the party that leads the current gov-erning coalition—the United Progressive Alliance—share this view.

2. J. Bradford DeLong, “India Since Independence:An Analytic Growth Narrative,” in In Search ofProsperity: Analytic Narratives on Economic Growth, ed.Dani Rodrik (Princeton, New Jersey: PrincetonUniversity Press, 2003), p. 186. Emphasis added.

3. Dani Rodrik, “Introduction: What Do We Learnfrom Country Narrratives?” in Dani Rodrik, ed., InSearch of Prosperity, p. 16.

4. N. K. Singh, who has been directly involved inpolicymaking in India during the 1980s and1990s, wrote the following to the author when hewas a member of the Planning Commission: “Iam somewhat intrigued by the statement ofDeLong & Rodrik stressing change in official atti-tude over change in policies implying that if atti-tude changed for good, growth would have beensustained even without reforms in the 1990s.Even today, more than change in policies we arestruggling with change in attitude. The firstreflex of any observer of Indian economy orpotential foreign investor would be that whilepolicies may not be so bad it is the attitude par-ticularly of official ones which becomes theAchilles heel. In fact the 80s and even the 90s haveseen far-reaching change in policies which havenot translated themselves fully into changes inattitudes. This attitudinal change indeed consti-tutes a major challenge in our reform agenda.” N.K. Singh, quoted with permission from personalcorrespondence.

5. Jessica Wallack found that with a 90 percent

probability, the shift in the growth rate of GDPtook place between 1973 and 1987. The associat-ed point estimate of the shift, statistically signifi-cant at the 10 percent level, was 1980. WhenWallack replaced GDP with GNP, however, thecutoff point with 90 percent probability shiftedto the years between 1980 and 1994. The associat-ed point estimate, statistically significant at the10 percent level, was now 1987. Wallack herselfnotes, “Although the evidence for the existence ofa break is strong, the data are more ambiguous onits exact timing in the early and mid-1980s.”Jessica Wallack, “Structural Breaks in IndianMacroeconomic Data,” Economic and PoliticalWeekly 38, no. 41 (October 2003): 4314.

6. The year 1980–81 was not included because the7.2 percent growth during that year was preceded bya 5.2 percent decline in GDP in 1979–80 and was,thus, artificially high. See Wallack, pp. 4312–15.

7. I have examined variances of growth rates dur-ing the 1990s and 1980s, taking various cutoffdates for the latter period. Irrespective of whichcutoff dates we choose for the 1980s, the variancewas higher in the 1980s.

8. In passing, the role of excellent agriculturalperformance in yielding the high overall growthrates during 1988–91 should also be acknowl-edged. Whereas years 1986–87 and 1987–88 werea disaster for agriculture because of bad weather,the subsequent three years, especially 1988–89,proved unusually good. According to the data inthe Indian government’s Economic Survey 2003,agriculture and associated activities (forestry andlogging, fishing, mining, and quarrying), whichaccounted for a little more than one-third ofGDP, grew at an annual average rate of 7.3 percentduring 1988–91.

9. Jagdish Bhagwati and Padma Desai, India:Planning for Industrialization (London: OxfordUniversity Press, 1970).

10. The Open General Licensing list identifieditems that could be imported without a licensefrom the Ministry of Commerce. Any item not onthe OGL automatically required a license fromthe ministry.

11. Ibid., p. 282.

12. Jagdish Bhagwati and T. N. Srinivasan offer afascinating political economy analysis of the 1966devaluation. In a key concluding paragraph on page153, they note, “The political lesson seems particu-larly pointed with regard to the use of aid as ameans of influencing recipient policy, even if, insome objective sense, the pressure is in the ‘right’direction. The Indian experience is also instructive

20

for the political timing of devaluation: foreign pres-sure to change policies, if brought to bear when agovernment is weak (both because of internal-struc-tural reasons and an impending election, whichinvariably prompts cautious behavior) can be fatal.”See Jagdish Bhagwati and T. N. Srinivasan, ForeignTrade Regimes and Economic Development: India (NewYork: National Bureau of Economic Research,1975), chap. 10.

13. See Gary Pursell, “Trade Policy in India,” inDominick Salvatore, ed., National Trade Policies(New York: Greenwood Press, 1992): 423–458.

14. Ibid., pp. 433–34.

15. Ibid., p. 441.

16. The decline in the share of canalized importswas due to increased domestic production offood grains, cotton, and crude oil and reducedworld prices of canalized imports such as fertiliz-ers, edible oils, nonferrous metals, and iron andsteel. Good weather and discovery of oil were par-tially behind the increased domestic output offood grains, cotton, and crude oil.

17. Vijay Joshi and I. M. D. Little, India: Macroeco-nomics and Political Economy: 1961–91 (Washington:World Bank, 1994), p. 184.

18. Pursell.

19. According to Joshi and Little, “The realexchange rate was again a critical factor as it depre-ciated by about 30 percent from 1985/86 to1989/90. Since Indian inflation in this period rosefaster than that of its trading partners, a devalua-tion of the nominal effective exchange rate of about45 percent was required and achieved. . . . Thisreflects a considerable change in the official atti-tude toward exchange rate depreciation. Thechange had already begun in 1983, but during 1983and 1984 action was restricted to keeping the realeffective exchange rate constant. From 1985onward exchange rate policy became more activethough the fiction of a fixed basket-peg was stillmaintained. From a presentational point of view,the sharp devaluation of the U.S. dollar, whichbegan in 1985, helped a great deal. A devaluation ofthe real effective exchange rate could be secured bykeeping the exchange rate or the rupee against thedollar constant, and in fact there was a mild depre-ciation in terms of the dollar as well. Cabinetapproval was sought and obtained to achieve thereal effective exchange rate prevailing in 1979 (thusoffsetting the competitive disadvantage that hadbeen suffered since then). When that objective hadbeen reached, cabinet approval was again obtainedto devalue the rupee further to maintain the com-petitive relationship vis-à-vis a narrower range of

developing-country ‘competitor countries,’ many ofwhom depreciated in real terms along with the U.S.dollar in 1986. This was a sensible exchange ratepolicy. Policymakers recognized that a realexchange rate devaluation was necessary thoughthe terms of trade were modestly improving,because the debt-service burden had increased anda faster growth of imports was to be expected in thewake of industrial and import liberalization.” Joshiand Little, p. 183. This view of the government tak-ing an activist role, shared by the author, is in con-trast to the view taken by T. N. Srinivasan andSuresh Tendulkar, Reintegrating India with the WorldEconomy (Washington: Insitute for InternationalEconomics, 2003), p. 23.

20. Pursell, p. 441.

21. Arvind Panagariya, “Miracles and Debacles: DoFree Trade Skeptics have a Case?” http://www.bsos.umd.edu/econ/panagariya/apecon/polpaper.htm.

22. Ashok Desai, “The Economics and Politics ofTransition to an Open Market Economy: India,”OECD Working Papers 7, no. 100 (1999): p. 21.

23. B. N. Goldar and V. S. Renganathan, “Liberali-zation of Capital Goods Imports in India,”Working Paper no. 8, National Institute of PublicFinance and Policy, New Delhi, 1990).

24. R. N. Malhotra, “Economic Reforms: Retrospectand Prospects,” ASCI Foundation Day Lecture,Administrative Staff College of India, 1992.

25. Joshi and Little, p. 260.

26. Satish Chand and Kunal Sen, “Trade Liberali-zation and Productivity Growth: Evidence fromIndian Manufacturing,” Review of DevelopmentEconomics 6, no. 1 (2002): 120–32.

27. Ibid., p. 128.

28. In the data used by Joshi and Little, real GDPis measured at 1980–81 prices. As such, theirgrowth rates differ from those computed fromreal GDP, measured at 1993–94 prices as in thispaper. Growth rates for the two periods when1993–94 is the base year are 3.7 and 4.8 percent,respectively. See Joshi and Little, chap. 13.

29. Ibid., p. 327.

30. See also Sandeep Bhargava and Vijay Joshi,“Faster Growth in India: Facts and a TentativeExplanation,” Economic and Political Weekly 25, no.48–49 (1990): 2657–62.

31. The Reserve Bank of India’s data differ signifi-cantly from the customs (DGCIS) data. Imports such

21

as offshore oilrigs and defense expenditures that donot go through customs but do enter the balance ofpayments presumably account for the discrepancy.

32. Joshi and Little, p. 186.

33. Srinivasan and Tendulkar. The Pay Commissionswere established to recommend civil service salaries.

34. The five sectors were (1) arms and ammunition,explosives and allied items of defense equipment,defense aircraft, and warships; (2) atomic sub-stances; (3) narcotics and psychotropic substancesand hazardous chemicals; (4) distillation and brew-ing of alcoholic drinks; and (5) cigarettes/cigarsand manufactured tobacco substitutes.

35. Government of India, Ministry of Industry,“Statement of Industrial Policy,” New Delhi, July 24,1991, http://siadipp.nic.in/publicat/nip0791.htm.

36. Government of India, “Tax Reforms Committee:Final Report, Part II,” New Delhi, Ministry of Finance,1993.

37. World Trade Organization, “Trade Policy Review:India,” 1998, http://www.wto.org/english/tratop_e/tpr_e/tp71_e.htm#Government%20report.

38. Jim Gordon and Poonam Gupta, “Understand-

ing India’s Services Revolution,” paper presented atthe IMF-NCAER Conference, “A Tale of Two Giants:India’s and China’s Experience with Reform,”November 14–16, 2003, New Delhi.

39. Montek Ahluwalia, “India’s Vulnerability toExternal Crises,” in Montek Ahluwalia, Y. V.Reddy, and S. S. Tarapore, Macroeconomics andMonetary Policy: Issues for a Reforming Economy(New Delhi: Oxford University Press, 2003):183–214.

40. Analysts such as Gurchuran Das tend to ignorethe changes made in the 1980s and attribute themto the July 1991 reform. But when one considersthe facts that 20 percent of the tariff lines werealready under OGL, that another 30 plus percenttariff lines including all consumer and agriculturalgoods were not freed until the end of 1990s, andthe top tariff line was still 110 percent, the July1991 reform was not as sweeping as it may seem.See Gurchuran Das, India Unbound: A PersonalAccount of a Social and Economic Revolution fromIndependence to the Global Information Age (New York:Alfred A. Knopf, 2001).

41. One suspects that under plausible assump-tions, this result would translate into largergrowth responses to larger initial distortions inthe endogenous growth models.

22

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