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Students Corner - A Decade of Economic
Reforms in India - A Review

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Reflecting greater investment demand in response to the major structural reforms undertaken in various sectors, the rate of domestic capital formation improved to 25.8 per cent of GDP during the second sub-period of Phase I. The slowing down of the structural reforms in the second phase along with the cyclical influences transmitted from the global uncertainties weakened the investment demand, resulting in significant slackening in the rate of domestic capital formation to a level of 23.9 per cent of GDP.

The industrial and trade policy reforms of 1991 resulted in significant acceleration in private sector investment in the early 1990s, and was particularly led by a robust increase in manufacturing investment. The high investment demand in the industrial sector, apart from being aided by policy reforms, was facilitated by an improved domestic saving rate. However, a decelerating trend in the rate of private corporate sector investment was observed during the latter half of the 1990s. Even though investment from the household sector continued to show a rising trend, investment from the private corporate sector could not keep up with the momentum it witnessed in the initial years of the 1990s. The pace of private investment originating from private corporate sector was, inter alia, inhibited by reduced saving from this sector, lack of adequate regulatory reforms in core and infrastructure sectors and lack of public investment in infrastructure. These factors could have inhibited private sector investment by imposing extra costs in a competitive environment. Besides these, increased uncertainties in the domestic investment climate created by factors such as poor progress and lack of clarity on the directions of disinvestments and privatisation programme, and the continued slowdown in the global economy, may also have dampened private investment.

High public investment in the 1980s was particularly aimed at boosting investment in infrastructure. However, public sector investment rate exhibited a steep fall during the 1990s which was caused by deterioration in public sector saving rate.The rising interest payments and rigidity in subsidies and wages pre-empted a larger part of the revenues and borrowed funds of the Government, leaving reduced resources for investment. Besides this, the declining tax-GDP ratio and low user charges on public infrastructure services reduced the ability of the Government to undertake investment in basic infrastructure. Further, the process of fiscal adjustment led to direct cutbacks on the capital expenditure of both Central and State Governments.

Among the three sectors, a steady downturn in investment rates was experienced by the agricultural sector during the decade of reforms. The decline in agricultural investment as a ratio of GDP came about from a decline in public investment rate on account of inter alia, rising subsidies, and also from the decline in private investment rate primarily owing to inadequate provision of infrastructure. The rate of investment in industry, accounting for the largest proportion of aggregate investment, exhibited a rise in the initial years of the reform decade responding to the major real sector reforms and associated anticipation of rising potential demand. This period of high investment was associated with high growth rate of GDP originating from the industrial sector. In the subsequent years, however, the rate of investment underwent a steep decline, as was the case with the rate of growth of output from this sector.

An improvement in the rate of investment needs to be supplemented by improvement in productivity in order to accelerate the rate of economic growth. The productivity of capital use, as measured by the Incremental Capital Output Ratio (ICOR), improved during the first half of the 1990s as exhibited by a steady decline in the filtered series of ICOR till 1997-98. As against this, an upward movement in the ICOR was observed during the subsequent period, reflecting the deceleration in productivity growth. Given the existing level of investment in the economy, the downward trend in productivity does not augur well for achieving and sustaining high growth rate.

The growth process during the reform period also seems to have been influenced by the behaviour of external demand. Traditionally, external demand has not been an important factor in influencing the behaviour of aggregate demand in India due to low degree of openness. However, during the 1990s, under a more liberalised trade and exchange regime, the degree of openness of the Indian economy rose considerably as reflected in higher ratio of foreign trade to GDP. Consequently, the pattern of exports has been exhibiting some degree of co-movement with global business cycles. The Granger causality between cyclical imports of industrial countries and India’s exports is significant and strongly bi-directional. Further, the cyclical output of industrial countries has unidirectional causal effect on output in India (RBI, 2002).

The magnitude of the influence of external demand on aggregate demand can be examined broadly in terms of export growth for the Indian economy. The average growth in exports rose from 8.3 per cent in the 1980s to 11.9 per cent during the first sub-period of Phase I ( i.e., 1992-93 to 1993-94) and further to 14.8 per cent during the second sub-period (i.e., 1994-95 to 1996-97). This seems to have provided significant impetus to the aggregate demand in the economy during the phase of high growth. In the subsequent period, under the influence of weakening global demand and lower growth in world trade volume, export growth experienced wide fluctuations and the overall export growth decelerated to 5.9 per cent during the second phase from 1997-98 to 2001-02. The world trade in goods and services exhibited a deceleration in growth from an average of 8.8 per cent during the period 1994-97 to 5.6 per cent during 1998-2001 (IMF, 2002). This, reinforced by the trade cycles, seem to have also contributed to the slowdown in the aggregate demand in the economy during the second phase of reform period.

Summing Up

The economy witnessed distinct improvement in growth during the first phase of reforms responding favourably to the initial productivity gains arising from reforms in the spheres of trade, industry and finance. This high growth was essentially led by a remarkable performance of the industrial sector. However, there was evidence of deceleration in the growth momentum in the second phase, mainly engendered by industrial sector, which has become a major policy concern. During the 1990s as a whole, the growth process was marked by robust growth in the services sector. The positive aspects of the growth process were an increase in the average growth of per capita income coupled with decline in the poverty ratio.

The slowdown in the domestic saving rate in the second half of the 1990s, mainly caused by public sector dis-saving, has constrained investment levels in the economy. The saving behaviour of the household sector shows that despite financial innovations, there is continued preference for relatively risk-free assets like bank deposits and contractual saving. The rising share of contractual saving reflects the rising disposable income and concerns for old age security. During the first half of the 1990s, the increased domestic saving enabled a rise in the investment rate in the economy. The slowing down of the structural reforms along with declining domestic saving rate and cyclical influences transmitted through global business cycles weakened the investment demand during the second phase of reforms. Declining public sector investment was reflective of the spill-over effects of rising revenue deficits on capital budgets of the Governments of both Centre and States. Besides a slowdown in investment, indications of declining productivity growth as reflected in rising ICOR during this phase, continue to pose challenges for the growth process.

Against this backdrop, the Tenth Five Year Plan (2002-03 to 2006-07) has set the target of an average rate of growth of GDP at 8 per cent, which is much higher than 5.5 per cent achieved during the Ninth Plan (Government of India, 2002a). This requires stepping up the average rate of investment by more than 4 percentage points to 28.4 per cent from 24.2 per cent in the previous plan. This order of increase in investment is expected to emanate from both private and public sectors. The Plan underlines the need to step up public sector investment in infrastructure to promote private sector investment. The higher investment level is to be met mainly by domestic saving, which is expected to rise by more than 3 percentage points to 26.8 per cent during the Plan from 23.3 per cent during the previous plan. A larger improvement in the saving to the extent of 3.8 per cent is required to come from the public sector. To achieve the growth target, the Plan suggests the formation of policies that would lead to an increase in productivity of existing resources as well as efficiency of new investment. This would imply a reduction in the ICOR to a level of 3.6 during the Plan period as against 4.5 in the previous plan.