MacroScan (Printable Version) - The RBI's Assessment of Indian Economic Reforms

It is rare for the Reserve Bank of India to make very definitive and even partisan statements about the broad contours of economic strategy. Central bank reports are normally fairly staid documents, attempting to present balanced if boring analyses of economic trends and policies. Over the past decade, as the other official economic publications have tended to be like publicity hand-outs for the government rather than objective assessments of the state of the economy, the RBI's publications have been more circumspect.

All that seems to be changing, along with so much else in economic institutions in India. The latest Currency and Finance Report of the RBI (officially referring to 2001–02 but published in April 2003) is for the first time organized around a theme: no less than an assessment of the economic reforms programme of the Government of India since 1991.

It is a bold attempt, and certainly valuable, given that it comes from this particular official quarter. The foreword (by RBI Deputy Governor Rakesh Mohan) and the opening chapter (on the theme of the report) give some indication of the underlying bias: 'The country has gained significantly from policy reforms in the 1990s. Further gains are there for the taking.' (pages I–3)

While it may be unusual for an official document to so openly wear its heart on its sleeve, it must be said that the subsequent chapters are much more carefully worked and worded. The various chapters present surveys of the literature and assessment of the team of writers, as well as a set of data pertaining to trends in the real economy, fiscal and monetary policy, the financial sector and the external sector.

Of course, there are major gaps and limitations even in the presentation of the broad trends. Thus, the entire report contains no mention of employment trends, as if employment is not and need not be a central concern of macroeconomic policy. Similarly, the report tends to uncritically accept the disputed argument that there has been a dramatic decline in the incidence of poverty, which is based on non-comparable consumption surveys conducted by the NSSO. Nevertheless, there is much in the report that provides an interesting and useful account of the economy under neo-liberal reforms.

Much of the trend analysis is conducted by comparing the pre-reform decade (here defined as 1982–82 to 1990–91) and the post-reform period (1992–93 to 2002–03), thereby excluding the 'crisis year' 1991–92 from the calculations. These data themselves tend to give the lie to the more optimistic assessment of the reforms that is presented in the overview chapter of the report, since they reveal a number of weaknesses even in the aggregate growth patterns.

In this edition of Macroscan, we focus on the evidence presented in the report on real economic growth, and consider the experience thus far with sectoral growth performance, as well as the underlying reasons for such performance.

To begin with, very recent trends in the economy suggest that economic activity has not only decelerated but is far below potential. Chart 1 shows that there is clear indication of deceleration in aggregate growth of GDP, despite fluctuations, in the last three years. This has been led by the poor performance of agriculture and allied sectors, but industrial growth also appears to be low over the recent period. Indeed, only the services sector shows relatively high growth rates, and even those have decelerated over the last three years.



This is related to the deceleration in investment ratios, evident from Chart 2. There has been a long-run tendency for savings and investment rates (as shares of GDP) to increase, reflecting the usual pattern in industrializing economies. However, this tendency appears to have come to a halt by the mid-1990s, and, by the early years of the current decade, the investment ratio had settled at between 23 and 24 per cent. More disturbing, the savings rate actually exceeded the investment rate in 2001–02 (and most probably also in 2002–03, for which the NAS data are not yet available).



This is an indication of the extent of slack in the economy, the aggregate unemployment and under-utilization of capacity. There is no question that the economy is operating well below potential, and the RBI also accepts this diagnosis. However, the RBI's own estimates of the potential income and the output gap are not based on the full deployment of existing resources. Rather, potential output is defined by some notion of 'structural factors' such as 'the lack of appropriate (undefined) reforms in the agricultural sector, infrastructure rigidities, labour market rigidities, weak bankruptcy and exit procedures’, which suggests that it is also operating within the narrow conceptual confines of the liberalizers.

The trend analysis of GDP confirms the picture of deceleration, especially over the most recent period. The RBI has calculated semi-logarithmic trend rates of growth for the relevant periods. While the trend growth rate of aggregate GDP is estimated to have increased from 5.6 per cent over 1981–82 to 1990–91, to 6.1 per cent in the period 1992–93 to 2002–03, this masks very differential performance across sectors. In fact, as Charts 3 to 10 show, both the primary and secondary sectors, as well as some important tertiary sectors have experienced deceleration of growth along with much greater volatility of growth as expressed in the coefficient of variation.

The sharpest deceleration is observed in agriculture, as apparent from Chart 3. It is worth remembering that the primary sector's long-run trend rate of growth since independence has been 3 per cent, and the post-reform period marks the first phase when it has actually fallen well below that. Indeed, this low rate of growth reflects the stagnation or even decline of agriculture in the more recent period, as we will discuss below.



It is true that this lower growth of agricultural GDP has been associated with lower volatility as well, but that reflects the tendency to stagnation especially in the latter part of the period. The report provides insufficient attention to the causes of this, and tends to underplay one of the more important aspects that has affected value added in agriculture (as opposed to gross production)-the impact of trade liberalization in keeping down many crop prices even when domestic output falls.

Mining and quarrying is clearly one of the sectors that has been adversely affected in the last decade. Chart 4 shows that GDP growth in this sector has decelerated; meanwhile, there is also much greater volatility of such growth. The coefficient of variation of GDP in this sub-sector was as high as 85 per cent in the latter period.



Manufacturing is more crucial to the Indian economy, and therefore it is disturbing to see from Chart 5 that the same tendencies are operative for this sub-sector as well. Deceleration of output growth has been accompanied by increased fluctuations, and it will become apparent that this is related to the even sharper slowdown in manufacturing in the latter part of the period.



This was accompanied by substantial slowdown and similar increase in volatility of the infrastructure and utility sectors, that are so important for manufacturing growth as well-electricity, gas and water supply (Chart 6).



It is only the services sub-sectors, described in Charts 7 to 10, that suggested any increase in rates of growth, and that is primarily why GDP growth in the aggregate has remained respectable. Even here, however, financing, insurance, real estate and business services registered a significant slowdown. Also, the acceleration in output growth of community, social and personal services may not reflect a real increase so much as the increase in public sector wages that occurred over this period because of the Pay Commission awards.







What explains this general deceleration in output growth in most sectors? The RBI report suggests that this reflects the more significant slowdown that has occurred after 1996, and therefore breaks down the post-reform period into three sub-periods for more detailed consideration.

Chart 11 gives some idea of this. It is clear that agricultural deceleration was the most advanced, with GDP growth in agriculture in the final five-year period averaging only 1 per cent per annum. But even manufacturing shows a sharp slowdown, falling in the last five years to only 4.2 per cent per annum-one of the lowest trend rates of growth experienced for Indian manufacturing in any period since the 1950s.



The stability of services growth over this period was clearly inadequate to counter these recessionary trends, which is why the period 1997–98 to 2002–03 also shows aggregate GDP growth at a lower rate of 5.3 per cent.

Over this later period, savings rates also declined on average. Chart 12 indicates that this was primarily due to the collapse of public sector savings, as the public sector became a net dissaver. Indeed, savings was kept afloat essentially by the household sector, since private corporate savings also declined as a share of GDP over this period.



Chart 13 takes a closer look at the distribution of household financial savings over the various five-year periods since the early 1980s. A number of features emerge from this chart. Currency has been declining as a share of total household financial savings, while more secure financial instruments have been gradually increasing. These include life insurance funds and net claims to the government (the so-called 'small savings').



Significantly, bank deposits have been growing in proportion throughout this period. Stockmarket instruments-shares and debentures-increased in the early 1990s, but after the stockmarket scam, households clearly decided to stick to less risky forms of saving. By the last sub-period they accounted for only 5 per cent of household financial instruments. The swing away from such stockmarket instruments clearly seems to have benefited small savings in the last period.

Investment rates also declined on average in the last sub-period, as illustrated by Chart 14. Interestingly, the decline in investment showed both public and private sector investment deceleration, while the household sector actually increased its investment (which is the same as its physical savings). This is but another reflection of the increasing slack, or unemployment and underutilization of resources, in the macroeconomy, that has already been mentioned.



Public sector investment was constrained by the falling tax–GDP ratios and the official perception that fiscal deficits needed to be contained, which meant cutbacks on public capital expenditure. There is no surprise in the associated decline in private corporate investment rates-the strong positive link between public and private investment in India (and indeed in most developing countries) is by now well-established, and the fact of recessionary tendencies in the economy during this period is also widely accepted.

The slowdown in manufacturing deserves closer attention. As Chart 15 shows, such deceleration was spread across a very wide range of manufacturing sub-sectors. So much so that only five sub-sectors appear to have bucked the adverse trend: beverages and tobacco, textile products, leather, chemicals and rubber, plastics petroleum and coal. For most of traditional manufacturing, as well as for the range of capital goods industries, the falls in growth rate were actually quite steep.



The RBI report considers at some length the various hypotheses advanced to explain the deceleration. It mentions the argument that has been advanced by Macroscan earlier, that the slowdown reflected the satiation of pent-up demand once the initial spurt of import-intensive production had dealt with post-liberalization consumer demand. Once that once-for-all increase had been catered to, manufacturing faced a recession in the absence of any further demand impetus, either from the domestic economy or through exports. This was aided by the fact that the initial early 1990s' expansion had not greatly increase employment, and so had limited linkage and multiplier effects.

The RBI appears to reject this argument, on the grounds that 'the huge capacity build up noticed in the first phase of reform runs counter to the monetary surge in demand that was not likely to be sustained in the long run' (pages III–30). However, this counter-argument is weak at best, and is actually contradicted by the data provided in the very same report, on capital goods production and import. It will be seen from Chart 16, that both domestic production and imports of capital goods really increased in the middle of the 1990s, and peaked by 1997–98, when the onset of domestic recession from 1996 finally dampened investor expectations. Since then, both production and imports of capital goods have been relatively depressed, indicating that investor expectations have yet to recover in the absence of any stimulus either from the government or from the external sector.



In addition, the report argues that the fall in government investment does not per se provide a satisfactory explanation of the slowdown, since government productive expenditure also declined during the short-lived boom. But that is precisely the point: that after that initial import-led consumption boom was over, the slowdown in government investment made things worse because there was no additional stimulus to private investment.

In contrast, the other explanations that have been offered for the manufacturing slowdown, which are apparently taken more seriously by the report, are almost laughable. The first relates to the 'credit crunch' faced by the corporate sector during 1995–96, when the RBI made large dollar sales to contain foreign currency market volatility. This could hardly explain the continued depression in investment until 2002–03. The important point about the credit market, which is not made in the report, is that the reduced access of small-scale industry to formal credit after financial deregulation has dramatically weakened its position and contributed substantially to the slowdown.

Similarly, the report argues that 'the proportion of corporate funds locked up in inventories and receivables went up steadily, leading to a scarcity of working capital' (pages III–30). This argument surely mistakes cause for effect-the increase in inventories is typically a sign of recession, not a factor determining it.

The report also mentions the role of cyclical factors, such as the lagged effect of low agricultural growth and the depressed international economic context. What it fails to mention is that it is precisely in such circumstances that expansion must come from government expenditure.

This reflects the basic constraint within which the report has been written, that it is operating very much within the paradigm of the marketist neo-liberal reform that the policy-makers in the Finance and other ministries have adopted. In the circumstances, it is hardly surprising that the Report is unable, despite its apparent intentions, actually to offer an objective assessment of the Indian reform experience.



Themes > Features	08.04.2003


The RBI's Assessment of Indian Economic Reforms

It is rare for the Reserve Bank of India to make very definitive and even partisan statements about the broad contours of economic strategy. Central bank reports are normally fairly staid documents, attempting to present balanced if boring analyses of economic trends and policies. Over the past decade, as the other official economic publications have tended to be like publicity hand-outs for the government rather than objective assessments of the state of the economy, the RBI's publications have been more circumspect. All that seems to be changing, along with so much else in economic institutions in India. The latest Currency and Finance Report of the RBI (officially referring to 2001–02 but published in April 2003) is for the first time organized around a theme: no less than an assessment of the economic reforms programme of the Government of India since 1991. It is a bold attempt, and certainly valuable, given that it comes from this particular official quarter. The foreword (by RBI Deputy Governor Rakesh Mohan) and the opening chapter (on the theme of the report) give some indication of the underlying bias: 'The country has gained significantly from policy reforms in the 1990s. Further gains are there for the taking.' (pages I–3) While it may be unusual for an official document to so openly wear its heart on its sleeve, it must be said that the subsequent chapters are much more carefully worked and worded. The various chapters present surveys of the literature and assessment of the team of writers, as well as a set of data pertaining to trends in the real economy, fiscal and monetary policy, the financial sector and the external sector. Of course, there are major gaps and limitations even in the presentation of the broad trends. Thus, the entire report contains no mention of employment trends, as if employment is not and need not be a central concern of macroeconomic policy. Similarly, the report tends to uncritically accept the disputed argument that there has been a dramatic decline in the incidence of poverty, which is based on non-comparable consumption surveys conducted by the NSSO. Nevertheless, there is much in the report that provides an interesting and useful account of the economy under neo-liberal reforms. Much of the trend analysis is conducted by comparing the pre-reform decade (here defined as 1982–82 to 1990–91) and the post-reform period (1992–93 to 2002–03), thereby excluding the 'crisis year' 1991–92 from the calculations. These data themselves tend to give the lie to the more optimistic assessment of the reforms that is presented in the overview chapter of the report, since they reveal a number of weaknesses even in the aggregate growth patterns. In this edition of Macroscan, we focus on the evidence presented in the report on real economic growth, and consider the experience thus far with sectoral growth performance, as well as the underlying reasons for such performance. To begin with, very recent trends in the economy suggest that economic activity has not only decelerated but is far below potential. Chart 1 shows that there is clear indication of deceleration in aggregate growth of GDP, despite fluctuations, in the last three years. This has been led by the poor performance of agriculture and allied sectors, but industrial growth also appears to be low over the recent period. Indeed, only the services sector shows relatively high growth rates, and even those have decelerated over the last three years. This is related to the deceleration in investment ratios, evident from Chart 2. There has been a long-run tendency for savings and investment rates (as shares of GDP) to increase, reflecting the usual pattern in industrializing economies. However, this tendency appears to have come to a halt by the mid-1990s, and, by the early years of the current decade, the investment ratio had settled at between 23 and 24 per cent. More disturbing, the savings rate actually exceeded the investment rate in 2001–02 (and most probably also in 2002–03, for which the NAS data are not yet available). This is an indication of the extent of slack in the economy, the aggregate unemployment and under-utilization of capacity. There is no question that the economy is operating well below potential, and the RBI also accepts this diagnosis. However, the RBI's own estimates of the potential income and the output gap are not based on the full deployment of existing resources. Rather, potential output is defined by some notion of 'structural factors' such as 'the lack of appropriate (undefined) reforms in the agricultural sector, infrastructure rigidities, labour market rigidities, weak bankruptcy and exit procedures’, which suggests that it is also operating within the narrow conceptual confines of the liberalizers. The trend analysis of GDP confirms the picture of deceleration, especially over the most recent period. The RBI has calculated semi-logarithmic trend rates of growth for the relevant periods. While the trend growth rate of aggregate GDP is estimated to have increased from 5.6 per cent over 1981–82 to 1990–91, to 6.1 per cent in the period 1992–93 to 2002–03, this masks very differential performance across sectors. In fact, as Charts 3 to 10 show, both the primary and secondary sectors, as well as some important tertiary sectors have experienced deceleration of growth along with much greater volatility of growth as expressed in the coefficient of variation. The sharpest deceleration is observed in agriculture, as apparent from Chart 3. It is worth remembering that the primary sector's long-run trend rate of growth since independence has been 3 per cent, and the post-reform period marks the first phase when it has actually fallen well below that. Indeed, this low rate of growth reflects the stagnation or even decline of agriculture in the more recent period, as we will discuss below. It is true that this lower growth of agricultural GDP has been associated with lower volatility as well, but that reflects the tendency to stagnation especially in the latter part of the period. The report provides insufficient attention to the causes of this, and tends to underplay one of the more important aspects that has affected value added in agriculture (as opposed to gross production)-the impact of trade liberalization in keeping down many crop prices even when domestic output falls. Mining and quarrying is clearly one of the sectors that has been adversely affected in the last decade. Chart 4 shows that GDP growth in this sector has decelerated; meanwhile, there is also much greater volatility of such growth. The coefficient of variation of GDP in this sub-sector was as high as 85 per cent in the latter period. Manufacturing is more crucial to the Indian economy, and therefore it is disturbing to see from Chart 5 that the same tendencies are operative for this sub-sector as well. Deceleration of output growth has been accompanied by increased fluctuations, and it will become apparent that this is related to the even sharper slowdown in manufacturing in the latter part of the period. This was accompanied by substantial slowdown and similar increase in volatility of the infrastructure and utility sectors, that are so important for manufacturing growth as well-electricity, gas and water supply (Chart 6). It is only the services sub-sectors, described in Charts 7 to 10, that suggested any increase in rates of growth, and that is primarily why GDP growth in the aggregate has remained respectable. Even here, however, financing, insurance, real estate and business services registered a significant slowdown. Also, the acceleration in output growth of community, social and personal services may not reflect a real increase so much as the increase in public sector wages that occurred over this period because of the Pay Commission awards. What explains this general deceleration in output growth in most sectors? The RBI report suggests that this reflects the more significant slowdown that has occurred after 1996, and therefore breaks down the post-reform period into three sub-periods for more detailed consideration. Chart 11 gives some idea of this. It is clear that agricultural deceleration was the most advanced, with GDP growth in agriculture in the final five-year period averaging only 1 per cent per annum. But even manufacturing shows a sharp slowdown, falling in the last five years to only 4.2 per cent per annum-one of the lowest trend rates of growth experienced for Indian manufacturing in any period since the 1950s. The stability of services growth over this period was clearly inadequate to counter these recessionary trends, which is why the period 1997–98 to 2002–03 also shows aggregate GDP growth at a lower rate of 5.3 per cent. Over this later period, savings rates also declined on average. Chart 12 indicates that this was primarily due to the collapse of public sector savings, as the public sector became a net dissaver. Indeed, savings was kept afloat essentially by the household sector, since private corporate savings also declined as a share of GDP over this period. Chart 13 takes a closer look at the distribution of household financial savings over the various five-year periods since the early 1980s. A number of features emerge from this chart. Currency has been declining as a share of total household financial savings, while more secure financial instruments have been gradually increasing. These include life insurance funds and net claims to the government (the so-called 'small savings'). Significantly, bank deposits have been growing in proportion throughout this period. Stockmarket instruments-shares and debentures-increased in the early 1990s, but after the stockmarket scam, households clearly decided to stick to less risky forms of saving. By the last sub-period they accounted for only 5 per cent of household financial instruments. The swing away from such stockmarket instruments clearly seems to have benefited small savings in the last period. Investment rates also declined on average in the last sub-period, as illustrated by Chart 14. Interestingly, the decline in investment showed both public and private sector investment deceleration, while the household sector actually increased its investment (which is the same as its physical savings). This is but another reflection of the increasing slack, or unemployment and underutilization of resources, in the macroeconomy, that has already been mentioned. Public sector investment was constrained by the falling tax–GDP ratios and the official perception that fiscal deficits needed to be contained, which meant cutbacks on public capital expenditure. There is no surprise in the associated decline in private corporate investment rates-the strong positive link between public and private investment in India (and indeed in most developing countries) is by now well-established, and the fact of recessionary tendencies in the economy during this period is also widely accepted. The slowdown in manufacturing deserves closer attention. As Chart 15 shows, such deceleration was spread across a very wide range of manufacturing sub-sectors. So much so that only five sub-sectors appear to have bucked the adverse trend: beverages and tobacco, textile products, leather, chemicals and rubber, plastics petroleum and coal. For most of traditional manufacturing, as well as for the range of capital goods industries, the falls in growth rate were actually quite steep. The RBI report considers at some length the various hypotheses advanced to explain the deceleration. It mentions the argument that has been advanced by Macroscan earlier, that the slowdown reflected the satiation of pent-up demand once the initial spurt of import-intensive production had dealt with post-liberalization consumer demand. Once that once-for-all increase had been catered to, manufacturing faced a recession in the absence of any further demand impetus, either from the domestic economy or through exports. This was aided by the fact that the initial early 1990s' expansion had not greatly increase employment, and so had limited linkage and multiplier effects. The RBI appears to reject this argument, on the grounds that 'the huge capacity build up noticed in the first phase of reform runs counter to the monetary surge in demand that was not likely to be sustained in the long run' (pages III–30). However, this counter-argument is weak at best, and is actually contradicted by the data provided in the very same report, on capital goods production and import. It will be seen from Chart 16, that both domestic production and imports of capital goods really increased in the middle of the 1990s, and peaked by 1997–98, when the onset of domestic recession from 1996 finally dampened investor expectations. Since then, both production and imports of capital goods have been relatively depressed, indicating that investor expectations have yet to recover in the absence of any stimulus either from the government or from the external sector. In addition, the report argues that the fall in government investment does not per se provide a satisfactory explanation of the slowdown, since government productive expenditure also declined during the short-lived boom. But that is precisely the point: that after that initial import-led consumption boom was over, the slowdown in government investment made things worse because there was no additional stimulus to private investment. In contrast, the other explanations that have been offered for the manufacturing slowdown, which are apparently taken more seriously by the report, are almost laughable. The first relates to the 'credit crunch' faced by the corporate sector during 1995–96, when the RBI made large dollar sales to contain foreign currency market volatility. This could hardly explain the continued depression in investment until 2002–03. The important point about the credit market, which is not made in the report, is that the reduced access of small-scale industry to formal credit after financial deregulation has dramatically weakened its position and contributed substantially to the slowdown. Similarly, the report argues that 'the proportion of corporate funds locked up in inventories and receivables went up steadily, leading to a scarcity of working capital' (pages III–30). This argument surely mistakes cause for effect-the increase in inventories is typically a sign of recession, not a factor determining it. The report also mentions the role of cyclical factors, such as the lagged effect of low agricultural growth and the depressed international economic context. What it fails to mention is that it is precisely in such circumstances that expansion must come from government expenditure. This reflects the basic constraint within which the report has been written, that it is operating very much within the paradigm of the marketist neo-liberal reform that the policy-makers in the Finance and other ministries have adopted. In the circumstances, it is hardly surprising that the Report is unable, despite its apparent intentions, actually to offer an objective assessment of the Indian reform experience.



© MACROSCAN 2003