Speech

Letting the Future In: India's Continuing Reform Agenda, Address by Anne O. Krueger, Acting Managing Director, IMF

June 4, 2004

Thank you, Nick. Let me say, colleagues and friends, that it is always a great pleasure to be back at Stanford and, especially, at this India conference that has become just as much a fixture on my calendar as on yours.

It is especially exciting to be here this time of course. The quite unexpected turn of events in India in the past three or four weeks has, alas, deprived us of some of the expected participants. It is hardly surprising that some people have much more pressing business to attend to. But for the rest of us, the fortuitous timing of this conference offers the chance to reflect on the problems and challenges facing India in the wake of the election.

Everyone here knows the economic challenges are considerable. But much has been already achieved: we should not underestimate the impact of the reform program that began in 1991 and for which, remember, Dr. Manmohan Singh was the driving force. I believe there is now an opportunity to be grasped. Building on the success so far and pushing ahead with an ambitious reform agenda could bring great rewards for the Indian economy, and for all Indians.

We have already had a session on the prospects for reform. I don't want to go over the same ground again. Instead I'd like to look at India's reform challenges in a somewhat broader context. I want to start by examining what the reforms have actually delivered; and to suggest what might be achieved if the reform program is given new, post-election, momentum.

Our job at the Fund is to support governments in their efforts to deliver the sustained and rapid growth needed to raise living standards and reduce poverty. We are not in the business of dictating policy priorities. That said, I believe that the official growth target of 7-8 percent, that seems to have been accepted by most, is not only attainable but that more can be achieved.

I think we can gain a better sense of what it is possible for a country like India if we look at what has been achieved in other countries through reform. We humans seem to be born with a strong preference for learning from our own mistakes, rather than those of others. But policymakers in India do have a wonderful opportunity to learn from the experience of other countries: they can see what has worked elsewhere, and what hasn't. Examining those countries that have made most progress, and why, is what informs my own judgment about the reform priorities that can do most to spur growth and speed poverty reduction in India.

The story so far

If we look back to the period before the early 1980s, we can see how far India has already come. Much was achieved by the reforms introduced by Rajiv Gandhi. They put an end to the `Hindu' rate of growth that had bedeviled the Indian economy. There was a marked acceleration of growth during the 1980s-even before the major reform program of 1991.

Several factors contributed to the acceleration of growth in the 1980s. First was the removal of some onerous controls on private sector economic activity. Second was the relaxation in the severity of quantitative restrictions on imports. The greater competition that these two developments brought about made productivity increases possible. A third contributing factor, though, was expansionary fiscal policy.

It's hard to know exactly how to interpret the more rapid growth we saw in the 1980s. The argument recently advanced by Rodrik and Subramanian in an IMF Working Paper is unconvincing, however, not least because it is incomplete. Part of the explanation for the pick-up in growth rates was increased efficiency-though not for the reasons advanced by Rodrik and Subramanian. Import liberalization and the removal of some burdensome licensing surely contributed significantly to productivity increases and more rapid growth in the 1980s. But fiscal stimulus was undoubtedly an important factor, and ensured that the pace of growth achieved in the 1980s was ultimately unsustainable.

The result, of course, was the twin crises of 1991 that ultimately led to the much more far-reaching reform program under Dr. Manmohan Singh's tenure of the finance ministry; this put the Indian economy on a sustainable growth path and permitted the acceleration of growth in the 1990s. Remember, the 1991 balance of payments crisis was extremely serious-reserves were almost exhausted. It became clear that radical action was needed: first to correct the balance of payments and fiscal crises; and second to ensure that more rapid economic growth in India could be sustained.

The 1991 reforms marked an important turning point because of they started the process of trade, financial and economy-wide liberalization in earnest. So it is disquieting to see the significance of those reforms played down by, for example, Rodrik and Subramanian.

The 1991 program was crucial in several respects. First, and most obvious, is that the reforms were started in response to the crisis situation. The earlier policy stance had been shown to be unsustainable. The shift in policy direction that resulted from the 1991 crisis brought both stability and the prospect of sustainability.

Second, trade liberalization was clearly essential: to make possible the increased productivity that import liberalization had brought to be sustained; and for export growth. And that was necessary for the faster growth in GDP we saw after 1991. It was also necessary to provide competition, and to ensure that the reforms of the 1980s did not simply deliver a form of crony capitalism.

Third, import liberalization brought competition for domestic industry. That competition may have been the biggest contributor to accelerated productivity growth.

And fourth, the Indian reform program would not have been credible without the opening-up of the economy. Had the economy remained as closed as it was, it is likely that the reforms would not have been sustainable, thus increasing the risk of another crisis.

It is clear that the reforms had considerable success. For much of the 1990s, India grew more rapidly that most other developing countries-averaging around six percent a year over the period since 1991.

In spite of what we've been reading in the newspapers in recent weeks, there has been a significant fall in poverty rates. One estimate suggests that nationally, the poverty rate dropped from just under 41 percent of the population in 1992-93 to less than 29 percent at the turn of the century. And the reduction in poverty has taken place in rural and urban areas: even in rural areas, the poverty rate had fallen to a tad over 30 percent in 2000; in urban areas, it was down to 24.7 percent.

These figures give the lie to all the commentators who have been arguing that the election result demonstrated the narrow and selective impact of India's reform program. More rapid growth did raise living standards and reduce poverty, as the numbers I've just cited indicate. What is needed now is more rapid growth combined with increased efficiency in the public sector's delivery of key social goods such as education and health.

The growth of the software industry in Bangalore and India's success in attracting outsourced services such as call-centers; the rise in middle-class ownership of cell phones and consumer durables; indeed, the growth of the middle class itself: these are all features of recent Indian economic development that have captured people's imagination. According to the post-election conventional wisdom, the focus on these achievements, and the failure to recognize that not everyone benefited, brought about the electoral backlash.

Some of the changes in India's economy and society are high-profile. Pictures of wealthy young Indians are bound to increase the sense among the poor that they have missed out. But when deciding how best to move forward it is important to have a clear understanding of where the problem lies.

The software and outsourcing successes of the past decade could not by themselves deliver growth rates of the sort we have seen recently. And as the figures I've quoted illustrate, the benefits of this growth have been more widespread than is often realized.

Of course, the poor have yet to benefit as much as they-or we-would like. And the benefits they have enjoyed-greater access to the outside world through television, for example-have to some extent increased their awareness of the living standards that others enjoy. But the solution is more rapid growth-not a switch of emphasis towards more redistribution. Poverty reduction is best achieved through making the cake bigger, not by trying to cut it up in a different way.

The poor will also benefit greatly from the improved delivery of government services, and more effective provision of education, health and infrastructure. It can be argued that the reforms of the 1980s made the license raj less onerous; and that those of the 1990s enabled the private sector to be more productive. More remains to be done in these areas, of course.

But reform of the government sector, with more efficient delivery of more and better services-education, health and infrastructure-is now the biggest challenge for further rapid growth. This is the virtuous circle that India now needs to aim for: growth makes all these things easier to provide, and they in turn free up resources needed for more rapid growth.

That is why I believe this is a moment of great opportunity. It is a chance to press on with the reform process that started in 1991 and that has, to some extent, faltered a little in recent years. It is a chance to aim for-and realize-the sort of high and sustained growth rates that will enable much greater reduction in poverty and much faster rises in living standards. The growth in excess of 7 percent achieved last year was, of course, impressive. But I believe India can do better than that, and needs to over a long period. The target needs to be sufficiently ambitious. In my judgment, with appropriate commitment, growth of 10 percent a year is both necessary and feasible.

What other countries achieved

There is no point in being timid, given the scale of the economic challenges that Indian policymakers must now confront. But nor is there any point in being unrealistic. Looking at what other countries have achieved quickly puts the target I'm suggesting into context. It can be done-because others have already done it.

Take Korea, which is a remarkable story of ambitions realized. As the United States started to reduce its aid program to South Korea in the 1950s, the accompanying debate about Korean economic prospects was overwhelmingly gloomy. It was taken for granted that the economy could not grow: incomes were very low, and the density of the population on arable land was then the highest in the word; savings and exports rates were very low. Most observers assumed that foreign aid would be essential even to maintain the existing low living standards.

The debate within Korea reached rather different conclusions: it was evident to Korean citizens that a country so poor in natural resources would have to rely on export growth if there was to be any prospect of sustainable economic expansion. By the early 1960s, a program of reforms had begun to take shape.

In 1960, Korean exports were equal to 3 percent of GDP and nearly 90 percent of those were primary commodities. A set of export incentives applicable on a non-discretionary basis to all non-traditional exports was introduced, along with a significant devaluation of the exchange rate. Exporters were given the right to import intermediate goods, raw materials and capital goods automatically and duty free. Exporters were also given access to low-interest loans and some tax rebates. By 1963, quantitative restrictions on imports had been greatly reduced, and exporters were those principally entitled to import.

The results were swift and dramatic. Exports had been worth $30 million in 1960; by 1964, that figure exceeded $100 million. The economy started to grow more rapidly.

In 1964, the reforms were extended, and fiscal reforms were undertaken as well, to restrict government expenditures to a level close to revenues. Subsequent fiscal accounts were close to balance, in part because of the rate of economic growth but also because tax collection was improved. Import restrictions continued to be relaxed further; and as the reform program progressed, the exchange rate regime was unified until the exchange rate was left as the main mechanism for providing incentives to exporting and import-competing producers. Imports and exports rose-from 13 percent to around 40 percent of GDP for imports and from 3 percent to 37 percent for exports. In that first decade after 1963, real GDP growth averaged 13 percent a year.

I should mention one other important aspect of Korean reforms that is important in the context of our discussions here. Throughout the whole of the reform period that spanned three decades, successive governments attached considerable importance to infrastructure improvements. Government policy explicitly recognized that ports, roads, telecommunications, and other infrastructure had a vital role in ensuring exporters' success.

Korea's economic advances were spectacular by any standards. By 1988, for instance, exports were 46 percent of GDP-fifteen times their share in 1960. Perhaps the single most striking feature of Korean growth is that it was sustained over a very long period. Between 1962 and 1992, per capita income rose almost sevenfold. By the late 1980s, Korea's economic success was such that it was regarded by some in the United States as a competitive threat.

Exports played an important part in the transformation of Korea, from a largely rural peasant economy in the 1950s to one of the most rapidly growing Asian tiger economies of the 1980s and 1990s. And this was achieved with a relatively equal income distribution. This should not be a surprise. No country has achieved a significant rise in living standards and a corresponding reduction in poverty without opening up its economy to the rest of the world.

If Indian policymakers are to realize their legitimate ambitions for sustained rapid growth and poverty reduction in one of the world's most populous countries, continuing trade liberalization will have a crucial role to play.

The challenge for India now

But if the new government continues to pursue reforms, the Indian economy could be tantalizingly close to moving to a path of sustained and rapid growth rates. The building blocks are there.

The 1991 reforms started in earnest the process of liberalizing the economy. They did much to free up the private sector-though much more needs to be done to reap the full benefits of competition. Naushad Forbes has documented the struggles that Indian exporters still face in their attempts to compete overseas. The bureaucratic hurdles that have to be overcome before goods can be permitted to leave the country would try anybody's patience. Yet streamlining procedures would be relatively uncontentious; and modest changes could have a significant positive impact. The problem is that at the local level, where such reforms must be implemented, there is no clear incentive for pushing through the necessary reforms.

More efficient government, and a reduction in costly and market-distorting subsidies, would increase productivity in the private sector. Streamlined government would also improve the delivery of public services.

Often the shortcomings in public service provision aren't about a shortage of funds. Corruption and mismanagement play an important part too. Recent research, presented at the Neemrana conference in January, shows that across India 25 percent of teachers are absent from school on any given day. That figure rises to 38 percent and 42 percent in the two states Bihar and Jharkhand with the worst record. And absence in private schools is nearly as bad-around two percentage points less than in public schools. The problem, as you might expect, is worse in remote schools-just where education can do most good.

More efficient government would free up resources within the public sector and enable the government to start closing the enormous infrastructure gap which will both increase the opportunities for private sector growth and benefit the poor. More careful targeting of government services will also ensure the poor benefit more than they have in the past. And more efficient and effective provision of government services will deliver the social and economic benefits so far lacking in some areas.

There needs to be further radical deregulation of private sector activity than we have seen hitherto. This will stimulate domestic entrepreneurial activity. It will also make India far more attractive to foreign investors.

These are laudable and important objectives. They cannot be achieved by the central government acting alone. The issue of center-state relations has to be tackled as well, since that by itself would unlock many of the reform bottlenecks.

Fiscal deficit

Tackling the fiscal deficit has to be an important priority. The progress already made in establishing a stable macroeconomic framework must be consolidated. A start has been made with the Fiscal Responsibility and Budget Management Act, of course. It is reassuring that the new government has restated its commitment to this (though less so that it proposes to delay the target date for budget balance to 2009).

But much more is needed. The best argument for fiscal reform over the longer-term is that the present position is unsustainable. But it would also free up resources for the private sector, helping to raise productive investment. Economies function most efficiently when governments concentrate on the efficient provision of public goods, and let the market allocate resources in the private sector.

India is not alone in confronting the consequences of lax fiscal control and rising public debt. The biggest single obstacle to tackling this problem in India's case has been complacency-because, so far, the large deficit, now in excess of 10 percent of GDP, has not inflicted as much short-term damage to the economy as might have been expected.

But deficits of this order of magnitude are simply not sustainable. That trouble has been avoided thus far should be a reason to take swift action to remedy the situation while there is still time and not an excuse for postponing the inevitable.

I am not advocating austerity, quite the opposite. A large part of the fiscal reform process in India would involve making the public sector more efficient, which would bring direct benefits to the poor. More efficient revenue collection and tax administration; a wider tax base; a more streamlined civil service; more carefully targeted transfer payments and the reduction of subsidies that benefit the middle class: these can all help improve the fiscal position while at the same time creating opportunities for growth elsewhere in the economy.

But reducing the government's reliance on borrowing will also free up resources for the private sector, and so contribute to more rapid growth and poverty reduction.

Governments elsewhere are discovering for themselves that fiscal discipline need not hamper growth. Turkey's recent growth performance is impressive: almost 6 percent last year, with 5 percent projected for 2004. Yet the government is running a substantial primary surplus, of more than 6 percent. Growth is now picking up in Brazil, another country with a primary surplus of 4.5 percent.

But other reforms need to be introduced at the same time, if the opportunities for growth that fiscal reform will bring are to be exploited successfully.

Infrastructure

Take infrastructure. The promises of infrastructure improvement made by almost everyone involved in the election campaign show that policymakers recognize how much India still needs to do to catch up. Government attention to doing things that the private sector can do better rather than to its core responsibilities helped deprive the country of good transport and communications networks, and of reliable energy provision, for decades. Here too a start has been made. But the task of bringing infrastructure into the twenty-first century is immense.

Rapid improvements to the infrastructure are vital. Better infrastructure will greatly benefit the poor, who have suffered most from inadequate transport, power and communications networks. But perhaps more important in the longer-term, improvements are urgently needed to increase private sector productivity. Sound infrastructure is essential for economic growth-which will also, in turn, benefit the poor. I mentioned the importance attached to infrastructure in the Korean context.

Social provision

As I said, more spending on infrastructure need not undermine fiscal discipline, it if is accompanied by efficiency improvements in the public sector. Similarly, it is a mistake to see better provision of education and health services for the poor as an alternative to tackling the fiscal deficit. For one thing, better targeting of social services provision can ensure increased benefits for those who need it at the same or less cost.

Center-state relations

There are clear opportunities for a rapid improvement in the provision of help to the poor that do not put macroeconomic stability at risk-indeed, as I've noted, the two aims can be mutually reinforcing. Or could be. One problem any government in Delhi faces is the split in responsibilities between the federal government and the states. Many of the problems of poor delivery of social services and inadequate infrastructure lie with the states, not with the central government.

A successful and sustainable fiscal policy can only be compatible with improvements in the provision of government services to citizens, especially the poorest citizens, if a start is made on resolving the problems of center-state relations. That might mean giving states the right incentives for reform. It could also mean states themselves learning from one another-the disparities in regional economic performance in India are striking.

Labor markets

There are good political reasons for focusing on needed improvements in the public sector. But further reforms are needed in the private sector, too-perhaps above all in the labor market. One argument that has been made for a large public sector in India is that it soaks up labor. Around 40 million people are already looking for a job in India, and another 35 million are likely to join them, within three years. Reform skeptics believe that cutting central bureaucracy and waste will simply add to that pool of labor.

Yet a lower fiscal deficit would reduce real interest rates, and thus free up resources straightaway. A more buoyant and productive private sector would create more jobs-though it is currently prevented from doing so on a large enough scale because of labor market regulation.

The jobs that hi-tech and service industries have brought India are, of course, welcome. But remember: this is a country with a billion people. India needs unskilled jobs on a large scale as well. A thriving labor-intensive manufacturing sector would deliver those jobs. It could only do so with far-reaching deregulation of the labor market. A more competitive environment for private industry would help bring the jobs that India needs, on the scale that it needs them.

The success of the software industry and the popularity of India as a base for back-office operations like call-centers illustrate what a dynamic private sector can do. But these two sectors are so successful in no small measure because they are exempt from the labor regulations that afflict so much of Indian economic activity. And they will not, of themselves, deliver the sort of growth-in GDP but also in jobs-that India needs. Freeing up the labor market across the economy would bring substantial rewards.

Foreign investment

So would more encouragement for foreign investors. Foreign direct investment (FDI) is still less than three quarters of one per cent of GDP in India. It is more than 3 percent in Brazil, and more than 4 percent in China. India accounts for less than one half of one per cent of global foreign investment-an amazingly low figure given both its geographical size and its natural resources. Regulation and red tape discourage foreign investors, many of whom still regard India as not worth the bother more than a decade after the ending of license raj.

Conclusion

I come back to my original point: this is a time of opportunity for the Indian economy. There is a real chance to build on the successes already achieved-which are significant, especially when compared with India's historical experience.

It is also clear at this stage in the reform process that the economic policy priorities that would bring most long-term economic benefit are those that would also benefit the poor, both directly and indirectly.

More rapid economic growth is essential for rising living standards and poverty reduction. But it is not enough by itself. The more rapid growth rates I think are feasible for India need to be accompanied by more jobs, apart from anything else. That makes labor market reform and more private sector competition essential.

Economic success is not some secret recipe known only to a few. We know what works, and why-and we have clear empirical evidence. India has already taken important steps in the right direction. Bigger steps, taken more boldly, would bring correspondingly greater rewards.

Thank you.