http://www.macroscan.org/fet/apr03/fet080403RBI_1.

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The RBI's Assessment of Indian Economic Reforms
April 2003

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.
Chart 7 >>
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').
Chart 13

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.

Chart 14
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.
Chart 15

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.

Chart 16

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.