1.24 The main strength of India's exports con- tinues to be in the traditional items - Agri- culture & allied products, textiles & garments, handicrafts and gems & jewellery. There has not been as yet a marked change in the composition of commodities or of markets which would indicate a structural change in our export sector. There is, how-
TABLE 6
Composition of exports
S.No. Commodity 89-90 90-91 91-92 92-93 93-94 94-95
1. Agricultural & allied 16.5 18.5 17.9 16.9 18.0 16.0
Product
2. Ores & minerals 5.0 5.3 5.2 4.0 4.0 3.8
(Excel coal)
3. Manufactured goods, 73.4 71.6 73.6 75.7 74.9 77.3
(i) Cotton yarn, fabrics,
made ups etc. 5.3 6.5 7.3 7.3 7.0 8.4
(ii) Readymade garments 11.6 12.3 12.3 12.9 11.6 12.4
(iii) Leather & leather manu-
factures including
footwear of leather 7.0 8.0 7.1 6.9 6.0 5.9
(iv) Handicrafts other than
gem and jewellery
(including handmade 3.0 2.8 3.7 3.8 3.5 3.1
carpets)
(v) Gems & Jewellery 19.1 16.1 15.3 16.6 18.0 17.2
(vi) Machinery, transport
equip, engg. goods,
metal product ,iron
and steel 12.0 12.4 12.6 13.4 13.6 12.7
(viii) Chemical & allied
product 7.2 7.2 8.3 6.6 6.7 9.6
4. Mineral fuels &
lubricants 2.5 2.9 2.3 2.6 1.8 1.6
5. Others 2.6 1.7 1.0 0.8 1.3 1.3
Total 100.0 100.0 100.0 100.0 100.0 100.0
7
ever, a significant increase in the buoyancy of exports in the traditional sectors, with new items entering the market and a steady, though slow, increase in the export of ma- chinery and engineering goods sector, all of which would be favourable for the mainte- nance of high growth of exports in the future [Table 6]. The sharp increase in export growth in the last two years has come after the
TABLE 7
Indices of Real Effective Exchange Rate
(REER) and Nominal Effective Exchange
Rate (NEER) of the Rupee (Base: 1985=100)
(10-Country Trade-based weights)
Year REER % variation NEER % Variation
(1) (2) (3) (4) (5)
1985 100.00 -1.9 100.00 -2.2
1986 88.92 -11.1 81.25 -18.8
1987 82.21 -7.5 71.01 -12.6
1988 77.48 -5.6 62.98 -11.3
1989 74.25 -4.2 56.84 -9.7
1990 67.86 -8.6 50.24 -11.6
1991 58.53 -13.7 39.09 -22.2
1991-92 55.68 35.96
1992-93 50.44 -9.4 29.52 -17.9
1993-94 50.54 0.2 27.50 -6.8
1994-95 52.72 4.3 26.36 -4.1
low level reached in 1991-92 due to the collapse of the rupee payment area (RPA) exports and a partial reemergence of the past rupee markets. To a large extent this revival is due to the greater utilisation of India's debt repayment obligations by Russia, which can- not be expected to grow in any significant manner nor contribute to India's foreign exchange position. The remainder, which is dollar denominated trade with the past RPA countries, holds out better prospects for the future.
1.25 In so far as exports to the "general cur- rency area" (GCA) are concerned, it maybe argued that the major impetus to growth arose initially from two sources : (a) the re- cession in the Indian economy during the period 1991-94; and (b) the substantial de- preciation of the exchange rate of the rupee since 1991. However, on the one hand the economy appears to have pulled out of the recession, and on, the other hand the 22 per cent depreciation of the real effective ex- change rate of the rupee between 1989 and 1993 has now started to get reversed [Table 7]. Thus the increased "pull" of the domestic market and the reduced level of export prof- itability will tend to lead to a slowing down of export growth unless new capacities with export capability are created rapidly. This requires not only that the investment pattern should be reoriented towards the exportables sectors, which is the basic objective of the reforms in any case, but also that the rate of investments be stepped up sharply in order to increase the supply of exportables and to expand the infrastructural facilities for the exporters.
1.26 In order to attain rapid growth in ex- port capability, export profitability must be greater than the return on domestic activity. The large gap that has existed between prof- its on domestic sales and on exports needs to be reduced substantially in order to attract investments in the exportables sectors. The steady reduction in the customs duty levels, and in non-tariff protection of import substi- tutes that has occurred since 1991 will certainly have a desirable effect, which should be examined in a somewhat longer time per- spective.
1.27 An analysis of the level of export incentives, degree of import protection and the relative position of exports and import
8
substitutes since 1966-67 is presented in Table 8. As may be seen, the export incentive index, defined as the ratio between the ex- port earnings index and the domestic price index, which was steadily eroded through the late 1960s and the 1970s, recovered somewhat during the 1980s, though not to the 1966-67 level. Post-1991, however, it con- tinued to improve and peaked in 1993-94 at 13 per cent above its level in 1966-67 and almost double its level in 1980-81. Since then it has reduced sharply and, if present trends continue, by 1995-96 it will be back more or less to the 1966-67 level and not very much higher than its level in 1990-91.
TABLE 8
BEHAVIOUR OF IMPORT PROTECTION AND EXPORT INCENTIVES
1966-67 1980-81 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97
World Price
Index (Pf) 1.00 1.51 2.03 2.10 2.18 2.25 2.33 2.41 2.50
Domestic Price
Index Rd) 1.00 2.72 5.41 6.14 6.77 7.36 8.19 8.93 9.56
Exchange rate for
Imports(
Rs/$) 7.50 7.89 17.95 24.52 30.65 31.36 31.38 32.00 32.50
Average import
tariff(%) 45% 110% 125% 105% 95% 70% 55% 40% 25%
Landed
Price
Index 1.00 2.30 7.55 9.72 11.97 11.05 10.43 9.95 9.33
Import
Protection
Index 1.00 0.85 1.40 1.58 1.77 1.50 1.27 1.11 0.98
Exchange gate for
Exports 7.50 7.89 17.95 24.52 28.95 31.36 31.38 32.00 32.50
CCS Rate 10% 10% 10%
REP/EXIM scrip
entitlement 15% 15% 15% 30%
REP/EXIM scrip
premium 25% 25% 25% 30%
Export Earning
Index 1.00 1.59 4.87 6.59 7.39 8.28 8.58 9.06 9.52
Export
Incentive
Index 1.00 0.59 0.90 1.07 1.09 1.13 1.05 1.01 1.00
Exp.Incentive/Imp.
Protection 1.00 0.69 0.64 0.68 0.62 0.75 0.82 0.91 1.02
NOTES: World Price Index = Weighted average of GDP deflators of 10 major trading partner = countries Domestic Price Index = GDP deflator for India Landed Price Index - Index of (1+t).e.Pf Import Protection Index = LPI/Pd Export Earning Index = Index of e.(1+CCS)(1+REP* Premium).Pf Export Incentive Index = EEI/Pd
9
1.28 Similarly, although the relative position of exports vis-a-vis import substitutes, as given by the ratio between the export incen- tive index and the import protection index, has improved substantially in 1993-94 and 1994-95, it continues to be 18 per cent below the level that prevailed in 1966-67. If pre- sent trends continue, by 1996-97 this ratio would more or less be at the level that pre- vailed in 1966-67, when India was nowhere near to being an export-oriented economy. In that case, neither the absolute nor the rela- tive position of exportables could be re- garded as having improved to any significant extent.
1.29 It is necessary to realise that the policy options available to the Government today for raising or even maintaining the absolute level of profitability of exports beyond A hat is determined by market forces are much more limited now than was the case earlier. As a part of the reform process, the Gov- ernment has given up almost all discretionary export incentive devices such as the cash compensatory support (CCS) and the im- port replenishment licence (REP). The only discretionary instrument left, other than the general waiver of income tax on export prof- its [sections 80-HHC/HHE of the IT Act], is the special import licence (SIL), which too will rapidly lose its incentive value as import liberalisation progresses further in the coming years. The possibility of reintro- ducing these devices is also limited since they may be barred by the latest GATT convention, and also because they run con- trary to the spirit of our economic reforms.
1.30 India's export growth in the long run will therefore necessarily have to be based on achieving competitive advantages through improved productivity and quality and on product and market diversification. Simul- tancously active export promotion measures will have to be continued for the immediate future if undue risks are to be avoided. Besides these measures the only direct in- strument presently available for active export promotion is the exchange rate, and there- fore an active exchange rate policy may be inescapable in the short run.
1.31 In particular, steps will have to be taken to ensure that the export regime is made considerably more "user friendly", which will necessitate substantial changes in a num- ber of areas, such as customs procedures and attitudes, warehouse and port/airport man- agement methods. export promotion schemes like export processing zone and export-ori- ented unit (EPZ/EOU)and advance li- cences (AL/VABAL). Some progress has been made in this front by the Export-Im- port policy (1992-97) and the various amendments which have been made to it from time to time. The highlights of the April 1995 Trade policy announcements are:
i) Export Promotion Capital Goods (EPCG) scheme enlarged.
ii) Advance Licence scheme expanded and liberalised.
iii) Rationalisation of schemes covering export-oriented units and export proc- essing zones, electronic hardware and software technology parks.
iv) Advance Customs Clearance Permit abolished.
v) Components, spares, parts of consumer durables freely importable.
vi) List of freely importable goods (OGL) expanded.
vii) Single window clearance for applications for setting up joint ventures or wholly- owned subsidiaries abroad.
1.32 In addition to these measures, consider- able attention will also have to be paid to rapidly expanding export infrastructure, which is already becoming a constraint. Wait- ing time in ports, for example have in- creased significantly over the past two years. Problems are also apparent in the infrastruc- ture necessary for specific export products such as high-speed data communication links for software exports and cold chains for the export of horticultural products.
1.33 The relative position of exportables to importables on the other hand appears to be moving in the right direction as the planned reduction in trade barriers progresses. How- ever, care needs to be taken that this process of import liberalisation does not lead to excessively high growth of imports during the transition phase. It has been estimated that under normal circumstances a growth rate of GDP of 6 per cent will require import growth of about 11 per cent. If, however customs duty rates decrease by about 10 per cent per year and there is an appreciation of the real exchange rate of around 5 per cent, the
10
consequent lowering of the relative price of imports may well lead to import growth at rates above 20 per cent if the price elasticity of demand is as low as 0.6. Such behaviour is already in evidence in 1994-95, when im- ports have been growing at almost 22 per cent. If this process continues for the next two years, India's import bill would be almost $42 billion by 1996-97. Even if exports continue to grow at the target rate of 18 per cent per year,which in itself is quite optimis- tic, the trade deficit will rise from the current level of about $3 billion to $6 billion in 1996- 97, which was the level that prevailed in 1990- 91. Exchange rate management again appears to be a major, if not the only avail- able, instrument to forestall such a possibility.
1.34 The role of the exchange rate goes be- yond just the trade issue. One of the pri- mary reason for the low current account deficits during the past two years has been the spurt in the inward remittances, which have gone up from the $2.5 billion level that had persisted for a long period to over $4 billion in 1994-95. This has been ascribed to a shirt in remittances from the havala route to legal channels. The principal reason why this shift has taken place is that the gross overvalu- ation of the rupee that existed in the past has been corrected thereby leading to a dramatic decline in the havala premium. -This process has also been supported by the growing confidence in the strength of the Indian econ- omy. If, however, the exchange rate gets misaligned, the havala premium may go up' again and if expectation builds up for ex- change rate depreciation, the flow of remit- tances may suffer a serious set back putting substantial pressure on the current account balance.
1.35 It needs to be reemphasised that the ex- change rate has now become much more central to management of the external sector than it has ever been before since the Gov- ernment is committed to removing or re- ducing all other forms of trade intervention. The introduction of current ac- count convertibility 'undoubtedly contributes to imposing a certain degree of discipline in the exchange rate policy of the Govern- ment, in addition to being a major support for market-oriented reforms. However, the market exchange rate is determined not only by current account transactions but also by financial flows, and the large inflows of foreign portfolio investments has put a strong upward pressure on the exchange rate de- spite a continuing current account deficit. Although the Government has managed to maintain a constant parity between the rupee and the dollar through foreign exchange market intervention, the real exchange rate has in fact appreciated quite significantly in the past two years. The problems that are likely to arise if this trend continues have been discussed above.
1.36 The substantial increase in foreign in- flows on the capital account are indicators of the international confidence in our eco- nomic potential and policy management, and as such can be regarded as a major success of our reform measures. But the inflow of foreign funds does not become inflow of for- eign savings until it increases the net in- flow of goods and services. otherwise it adds to foreign exchange reserves, which un- doubtedly contributes to the confidence in the country's external account viability. But it also creates problems in management of the interest rate and money supply.As regards servicing of these foreign inflows the advantages of foreign direct investments (FDI) over foreign borrowings are quite clear. in that the former needs to be serviced only when the investments start to yield returns. As regards foreign portfolio investments (FPI), the relatively high average returns to investment, including capital gains, in India compared to international interest rates call make them a more expensive source or funds for the country than foreign borr- wings, without the advantage of the stability of direct investments. Such funds tend to be more volatile and less predictable than bor- rowings, which have well defined repayment schedules. Indeed, the most worrisome fea- ture of foreign portfolio investments, which has been documented in the case of a number or other countries, is that it tends to behave pro-cyclically, i.e it flows in when the eco- nomy is performing well and flows out when the economy is in a downturn. Such behaviour makes the task or macro-manage- ment that much more difficult. It may therefore be necessary to maintain some amount of control, by using price-related market-based Instruments, On their inflows and outflows at the initial stage of our reform process.
4. The Fiscal Balance 1.37 The decade of the 1980s was charac- terised by Government revenue expendi-
11
tures outstripping revenue receipts consis- tently on an increasing trend. By 1990-91 the fiscal deficit of the Central Government had risen to the order of 8.4 per cent of GDP. This was financed by, increased borrow- ings both at home and abroad. The external debt problem faced by the country in 1990- 91 was largely the outcome of this behaviour. In addition, the domestic debt contracted by the government to bridge the deficit led to a rapid increase of about 20 per cent per annum in the interest payment liabilitites over the 1985-90 period. It was clear that no stabilisation effort could be sustained un- less the deficit was brought down to reason- able levels and contained. The strategy for achieving this objective was based on three planks : (a) increasing tax revenues; (b) re- ducing revenue expenditures, particularly subsidies, both open and hidden; and (c) reducing the need for public investments in infrastructure through encouraging greater private sector participation. In order to im- pose fiscal discipline on itself, in September 1994 the Government entered into an agree- merit with the Reserve Bank of India to the effect that money finance of the deficit will be gradually brought down to NIL by 1997-98.
1.38 A comprehensive reform of both the direct and indirect tax systems in India formed the cornerstone of the economic reforms programme. This was based on the Report of the Tax Reforms Committee set up by the Government in 1991. An essential element or the tax reform package was predi- cated on the desirability and need to bring down the average level of customs duty from above 100 per cent in 1990-91 to about 25 per cent within a reasonable period of time. The fall in revenus. if import volumes did not increase correspondingly and simulta- neously, on this account would have to be made up from other sources.
1.39 The main philosophy guiding tax re- forms in the sphere of direct taxes was to choose moderate rates on a wider base and to ensure better tax administration. The ap- proach appears to have paid dividends with a substantially higher collection of direct taxes in the last three years. The num- ber of personal income tax assessees has also increased significantly during the past year. However, there continues to be substantial scope for higher revenues via tighter admini- stration. The total number of' personal in- come tax assessees comprises less than one percentage point of the population, and the total collection of direct taxes, personal and corporation combined, is only about 2.8 per cent of GDP as against the average of around 5.5 per cent for developing coun- tries. There also appears to be scope for tax- ing fringe benefits and further widening the ambit of presumptive taxes, which have so far' yielded low revenues. Further, ex- empting financial assets from the ambit of wealth tax can be questioned since such exemptions militate against the canon of horizontal equity.
1.40 In the sphere of indirect taxes, the com- plex system of high and multiple rates, with numerous exemptions, and different rates being applicable for the same good for different uses and users had resulted in ad- ministrative abuse, mounting litigation and uncertain allocative impact. It had also nar- rowed the tax base, made the system inelas- tic, while creating serious economic distortions. The reform proposals in this sphere have aimed at simplifying and ra- tionalising the structure and continuing the process of moving towards moderate rates of taxation. This approach appears to have yielded improved results. Even in the case of customs duties, the efforts at unifying rates on similar products and pruning of noti- fications, including end-use exemptions, has led to a situation where the reduction in the average customs revenue collection rate has been about 34 per cent as against 40 per cent reduction in the average nominal duty rates between 1990-91 and 1994-95.
1.41 Despite the improved elasticity of tax revenues in the post-reforms period, the ab- solute growth in revenues has been disap- pointing. Tax collections had increased at an average rate of 16.5 per cent per annum between 1980-81 and 1990-91. Since then, it has slipped drastically to only 8.2 per cent in the 1991-94 period. In 1994-95, however, it has again picked up sharply by 19.3 per cent. Despite this revival, die tax revenue to GDP ratio will be almost one percentage point below the level obtaining in 1990-91.
1.42 This pattern highlights the importance of the manufacturing sector to the Govern- ment's fiscal viability, since most of these changes can be ascribed to the growth per- formance of this sector alone. It needs to be borne in mind that it is the manufacturing sector which contributes almost all of Union
12
Excise and Customs duties, and most of the Corporation tax. Indeed, it is this sector which directly or indirectly contributes al- most 70 per cent of the Central Government's tax revenues despite accounting for only about 28 per cent of GDP. The dependence of the state government revenues on the manufacturing sector is only slight]), less than that of the Centre. Therefore, in the longer run, the financial health of the gov- ernment, both Centre and State, is closely linked to the growth performance of the manufacturing sector, unless deliberate ef- forts are made to reduce the level of fiscal dependence.
1.43 Efforts at containing Government ex- penditures too have borne fruit, with the total expenditure of the Centre being reduced from 20 per cent of GDP on an average during the 1980s to about 18 per cent in the post- reform period. The bulk of this 2 percentage point reduction is on account of capital expen- ditures, which has gone down from 6.1 per cent of GDP to 4.4 per cent, le. by 1.7 per- centage points. As a consequence, the share of capital expenditure in the total expenditure has declined sharply from around 30 per cent to 24 percent. As far as revenue ex- penditures are concerned, it needs to be noted that the only component that has increased is interest payments, which has gone up from 4 per cent of GDP to 4.6 per cent Other revenue expenditures have come down from 9.9 per cent of GDP to8.9 per cent. Thus, the 6 per centage point decline in the share of capital expenditures in the total is matched by an almost corresponding in- crease in interest payments, with other reve- nue expenditures remaining more or less constant at 49 per cent of the total expendi- ture. This behaviour is reflected in the fact that while the fiscal deficit to GDP ratio has declined relative to 1990-91, the revenue deficit has gone up sharply.
1.44 The rapid increase in the interest pay- ments is a matter of serious concern. If it is not brought under control, the Govern- ment will have to reduce all other forms of expenditure much more rapidly than may be desirable in order to achieve the target fiscal deficit to GDP ratio. It is therefore important to examine the underlying causes behind the burgeoning interest payments. In this context, two observations need to be made. First, the sport in interest liabilities has taken place only since 1993-94. The first two years after reforms had witnessed a remark- able slowing down of the rate of growth inter- est payments. Second, the reported interest liabilities of the Government actually un- derstates the extent of the growth that has taken place in reality. The reason for this is that the reported figures are on a cash basis, and not on accruals. Therefore, the recent increase in the issue of zero coupon govern- merit bonds of about Rs. 3000 crores face value gets reflected in the stock of public debt but not in the interest liability.
1.45 Despite the deferring of interest liabili- ties through greater recourse to zero cou- pon bonds, the average interest rate on public debt has increased sharply from 8.0 per cent in 1990-91 to 9.3 per cent in 1994-95. The bulk of this increase is on account of the average interest rate on internal liabili- tics which went up by 0.7 percentage points in 1993-94 alone. The decision to shift from fixed yields on government securities to mar- ket determined Yields on all new issues in order to reduce the burden on the banking sector, has led to a sharp increase in the interest rate on new government debt, which have risen from 11 per cent in 1989-90 and 1990-91 to 13.2 per cent in 1993-94. This has been fur- ther compounded, particularly for state gov- ernments, by the reduction in the statutory liquidity ratio (SLR) from 38 per cent to 29.5 per cent by 1994-95. The Public Sector Under- takings also have had to face problems arising out of the increased costs of borrowings in the context of reduced budgetary support.
1.46 The average interest rate is likely to rise further for the next few years as older lower cost debt is retired and replaced by the higher interest bearing new debt and as the SLR is brought down to the target level of 25 per cent by 1996-97. This process is likely to continue until the average interest rate on government debt becomes equal to the market rate, unlike in the past when the gov- ernment paid substantially lower interest on its debt than the market rate. Therefore, un- less the market rate itself comes down by about 4 percentage points, the debt servic- ing burden will continue to increase on this count alone.
1.47 The second principal cause for the rapid increase in interest payments is the substan- tial increase in net government borrowings in die past two years. This figure has gone up from about Rs.33,000 crores during 1990- 91 to above Rs.49,000 crores in 1993-94
13
and further to Rs.55,000 crores in 1994-95, after having declined mildly in 1991-92 and 1992-93. The main reason for this sharp increase in borrowings is the decision by the Government to reduce the extent of money finance of the fiscal deficit in order to control inflationary pressures. Thus, al- though the fiscal deficit in nominal terms rose by Rs.20, 100 crores in 1993-94 over 1992- 93, government borrowings rose by Rs.21,700 crores. The figures are even more striking for 1994-95, when the fiscal deficit rose by only Rs. 800 crores, but bor- rowings rose by Rs.5,700 crores.
1.48 The level of public borrowings would have been even higher but for the receipts from the sale of public sector equity, which has averaged a little above Rs.3500 crores per year in the last two years. There has been
TABLE 9
Inflation Rates in Pre- and Post-Reform Periods
(per cent per annum)
Pre-reform period Post-reform period
1985-86 to 1990-91 1991-92 to 1993-94
All commodities 7.8 10.7
Food Grains 7.4 13.3
All Food articles 8.4 12.3