Toward an Economic Overhaul
Assessing India's "Big Bang" Reforms
To assess what recently announced reforms may mean for India’s economic outlook and political process, NBR spoke with Arvind Subramanian, a senior fellow at both the Peterson Institute for International Economics and the Center for Global Development.
On September 14, Indian prime minister Manmohan Singh announced a series of “big bang” reforms intended to overhaul the country’s sluggish economy and restore investor confidence. In addition to allowing 51% FDI in multi-brand retail, the reforms will increase outside investment in three key sectors—aviation, insurance, and pensions—by allowing foreign airlines up to a 49% stake in India’s civilian aviation sector, allowing up to 49% investment in insurance, and opening pensions for investment, an area previously closed. The government has claimed that opening up the retail sector alone will bring India $700 million in investment and employ 20 million people within three years.
Simultaneously, the Indian government announced a 14% increase in diesel prices in an attempt to reduce subsidies in this sector and bring the country’s budget deficit under control. Diesel and cooking fuel subsidies are estimated to cost India $15 billion a year, which is roughly 1% of GDP.
This push for reform comes during a year when India’s economic and political performance has faced considerable scrutiny. The budget received low marks because it did not include expected major reforms and called for a series of new tax proposals that greatly worried foreign investors. As a result, the economy slumped and Standard & Poor’s downgraded India’s outlook from “stable” to “negative.” There was also no movement on allowing majority foreign investment in India’s retail sector by companies like Wal-Mart and IKEA, a decision the government approved in November 2011 but abruptly canceled after receiving significant political pressure.
Concerns over policy paralysis and charges of political corruption also abounded. Many analysts questioned whether Prime Minister Singh’s Indian National Congress Party had the interest or ability to push forward meaningful changes while facing great opposition from the Bharatiya Janata Party (BJP), as well as within its United Progressive Alliance (UPA) coalition from West Bengali chief minister Mamata Banerjee and others.
To assess what the recently announced reforms may mean for India’s economic outlook and political process, NBR spoke with Arvind Subramanian, a senior fellow at both the Peterson Institute for International Economics and the Center for Global Development.
What was the impetus for Prime Minister Singh’s government to initiative significant reforms at this time?
For some time, India’s macroeconomic situation had been deteriorating, reflected in near double-digit inflation (for three years), a fiscal deficit of 10% of GDP, and a rising external deficit. Investor sentiment had been turning negative, resulting in capital outflows and a declining rupee, which had gone from about 48 to 56 to the U.S. dollar. But the straw that broke the camel’s back was a plunge in economic growth to 5.5% and was threatening to become a medium-term feature rather than signaling just a cyclical decline. Rating agencies were threatening to downgrade India to below investment grade status. Had that happened, the Indian government and companies would have had to pay higher interest rates on their borrowings, and foreign capital would have once again fled India.
There was a Cabinet reshuffle. Palaniappan Chidambaram came back as finance minister and with the blessing of UPA Chairperson Sonia Gandhi initiated reforms to rescue India from a real slide. Mr. Chidambaram, widely viewed as a pro-reform minister, had been the commerce minister in 1991 when the current prime minister undertook wide-ranging reforms.
In the past, the Indian government has faced significant backlash to economic reforms, including the protests that prompted the government to reverse its decision last December to open the economy to foreign investment in multi-brand retail trade. How politically sensitive do these UPA reforms continue to be among the government, opposition parties, and the general public?
Reforms involving opening up the economy are always politically sensitive in India. But over time, there has been an ideological shift toward recognizing the benefits of opening up. This helps overcome some of the political opposition to reform. For example, with respect to the entry of Wal-Mart, there is opposition from the small retailers, but this is balanced by the understanding that farmers might benefit considerably from opening up because of better refrigeration, transportation, and marketing of agricultural produce. So in some ways the politics of reform are slowly evolving in a manner that makes opening less politically difficult. But opening will never be easy.
In addition to attracting increased foreign investment, the measures announced mid-September were also intended to address India’s fiscal deficit. Do the reform measures successfully address this problem?
The reform measures only begin to address the fiscal deficit, which will be key to restoring macroeconomic stability in India and bringing down inflation. It is estimated that the current measures will reduce the deficit by about 0.1%–0.2% of GDP. The main steps that still need to be taken include further reducing subsidies and implementing the new value added tax, called the Goods and Services Tax (GST). Explicit subsidies—for fuel, fertilizer, food, and power—cost the government about 2% of GDP, and the current measures only address one aspect of the fuel subsidy, specifically that for the use of diesel. Implementing the GST will require amending the constitution, which can only be done if the opposition parties support the government at both the federal and state levels. This would help lower the deficit from 10% of GDP—which is close to the deficit in the United States. Inflation would then also come down, foreign borrowing would be reduced, and investors would have greater confidence in the Indian economy.
What other measures might help address India’s deficit and subsidy burden?
One really promising program in India—which has the potential to address the subsidy burden—is called the Unique Identification Program, under which all India citizens are getting biometric identification. Once identifying people becomes easier, it will also become easy to target those who need to be supported. Then, all the subsidies that do not reach the truly needy can be reduced or eliminated and can be replaced with direct targeted cash transfers. The government can thus redistribute wealth, but with less waste and fewer distortions. For example, the power subsidy has led to overuse of water in rural India, and as a result water is becoming more scarce, which is very detrimental in the long run.
Despite the country’s economic and political challenges, foreign institutional investment in India continues to grow. Can you explain this trend and what it says about how foreign investors view the Indian market?
Foreigner investors continue to find India attractive because the country’s economic growth, even at 5%–6%, is higher than in most parts of the world and in absolute terms is substantial because of the size of India’s market. India holds the potential for much more rapid growth—about 8%—so investors want to secure a foothold for the future, even if the present is a bit bumpy.
The UPA’s latest economic reforms have been compared to those Prime Minister Singh shepherded in 1991–92 as finance minister. Are these comparisons justified?
The comparison is misplaced. In the early 1990s, India faced a true macroeconomic crisis and had to borrow money from the International Monetary Fund because the country had very little foreign exchange of its own. Commensurately the actions were bold and involved nothing less than dismantling the socialist model of development: wide-ranging controls on trade and domestic production were reduced or eliminated, access to foreign exchange was liberalized, and the scope of the public sector was reduced. This time, the crisis is not as severe—India’s growth today is 5.5% compared to negative growth in 1991—and hence the responses have not been remotely as ambitious.
If the reforms are implemented, what might be the short-term and long-term effects?
The immediate effect has been to partially restore investor confidence, enabling the rupee and stock market to bounce back. But the reforms will only have a lasting effect if the policy actions translate into more investment and higher growth. For example, it remains to be seen if companies such as Wal-Mart will increase their operations in India and if foreign airlines will enter the Indian market and buy up some of the existing companies that are teetering at the edge of bankruptcy.
Arvind Subramanian is senior fellow jointly at the Peterson Institute for International Economics and the Center for Global Development, where he leads CGD’s Understanding India initiative.
This interview was conducted by Sonia Luthra, Assistant Director for Outreach at NBR.