Reforms: The Second Generation

12 February, 2000, C.P. Chandrasekhar

If official spokesman are to believed, the Vajpayee government is busy putting in place a new generation of economic reforms. The forthcoming Budget too, it is expected, will push ahead with what has been termed "second generation reform". And such expectations have been fuelled by a series of liberalisation measures announced in recent weeks.
The emphasis on a generational difference when speaking of the current reform effort is, however, not easy to comprehend. It seems to suggest that what is being implemented by the Central government is not just more of the same set of policies adopted during much of the 1990s, but a qualitatively new set. 
The evidence to support that view is, however, hard to find. It is indeed true that among the economic "achievements" of this government during its "first 100 days" are counted its ability to pass, or revive discussion on, a set of economic bills. These include legislation to open up the insurance sector to private entrants, which has been passed, and the revised Patents Act, which has been referred to a Select Committee. However, the matters dealt with in these bills are by no means new. They have been periodically raised throughout the reform process and had to be shelved in the face of controversy. In fact, in some cases such as the revision of the Patents Act, efforts by the earlier Congress government to push ahead with reform where stalled in part by the BJP itself. 
The second area of "progress" in the current reform effort is the widening and intensification of trade liberalisation, by reducing quantitative restrictions and reducing tariffs. In this area, there are two forms in which the reform is sought to be "advanced": first, through the inclusion of a range of consumer goods in the list of freely importable goods; and second, through sharp reductions in customs tariffs. Tariff reduction has been effected in almost every budget since 1991. And the liberalisation of consumer goods imports began in right earnest in the Exim Policy announced last year by the then Commerce Minister Ramakrishna Hegde. Thus, the decision of the Vajpayee government to succumb to US pressure and advance the date (set by WTO commitments) by which a range of quantitative restrictions are to be phased out, merely accelerates a process which has been underway for sometime.
The third area of advance relates to regulations with regard to foreign direct investment. The number of areas where automatic approval is accorded to foreign investments, virtually independent of the share of foreign equity holding in the enterprise concerned has been expanded so substantially, that the role of the Foreign Investment Promotion Board (FIPB) has been diluted to a state of near non-existence. Early in February, the Government increased the ceiling on foreign direct investment (FDI) through the automatic route in eight sectors. The eight sectors where ceilings have been enhanced by margins ranging from 23 to 100 per cent are drugs and pharmaceuticals (revised ceiling of 74 per cent), pollution control machinery (100 per cent), coal and lignite sectors (50 per cent) for operating power plant, mining and coal processing, tourism (51 per cent), mining (74 per cent), prospecting for gold and diamond (100 per cent), advertising (74 per cent) and film industry (100 per cent from 0 per cent). This,declared Industries Minister Murasoli Maran, was only a beginning. While this does constitute a significant shift in the attitude towards foreign investment, here again the trend towards greater and greater liberalisation of conditions and terms of entry, in pursuit of a $10 billion FDI target, has been visible for quite some time now. 
Finally, recent weeks have seen a spate of measures aimed at liberalising financial sector controls. Not merely are the terms of profit repatriation by foreign entities in India being eased, but domestic corporates are now allowed to freely access equity capital from abroad, with no clearance required for the issue of ADRs and GDRs, as well as access international credit in larger volumes through a substantial relaxation of External Commercial Borrowing (ECB) guidelines. Now all end-use restrictions on the use of foreign loans, excepting for investment in real estate and capital markets, have been removed. Further, companies are allowed to borrow up to $200 million to finance their equity investments in subsidiaries or joint ventures executing infrastructure projects. And, the ceiling on foreign exchange exposure for financing project costs in the insurance and export sectors have been raised from 30 per cent to 50 and 60 per cent respectively. Clearly, the earlier policy of permitting less restricted access to international capital is being replaced by one of which opens the floods gates to foreign portfolio capital and credit inflow. 
Yet, put together these initiatives merely imply a change in the pace and extant of reform rather than a change in the direction of reform influenced by advice from the Bretton Woods twins. They could constitute a qualitatively new phase of reforms only inasmuch as it can be argued that quantitative changes result at some critical point in a qualitatively new economic environment. 
There are, however, grounds to hold that such a critical stage has been reached. The first, of these stems from the growing evidence that, it is not just small and medium-sized domestic firms that are endangered by liberalisation, but large ones as well. Through take overs of Indian firms, buy-outs of joint venture partners and a growing trend for international firms involved in joint ventures to establish wholly owned subsidiaries, making use of the more liberalised dispensation, domestic big business is beginning to feel the heat of multinational competition. Second, with import liberalisation having reached critical levels, domestic industrial and agricultural producers are being devastated by international competition. This has resulted in a situation where not only is the government forced to impose relatively high duties on commodities like wheat and sugar, but even foreign automobile companies in India have begun to whine about the dangers of freeing imports of second hand cars, for example. 
But above all, a combination of import liberalisation, liberalisation of FDI rules and relaxation of controls on domestic private entities accessing international finance, has created a situation where the use of foreign exchange has been delinked from any responsibility to earn the foreign exchange to meet the costs of relying on foreign funds. The foreign exchange required to finance indiscriminate imports, service interest payments and amortisation costs on debt, and pay technical fees, royalties and dividends associated with foreign direct investment are to be drawn from the central pool. Yet there are no measures to ensure that those drawing on that pool contribute to it as well. Even foreign investors, who are being permitted better repatriation terms, are targeting the domestic rather than the export market. This reduces their contribution to the foreign exchange pool to the initial sum they bring in as investment, which, given time, falls short of the continuous outflows of foreign exchange associated with their operations in the country.

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Thus far similar liberalisation efforts have not proved to be a problem since low oil prices and large inflows of remittances from India workers abroad (amounting to $10-12 billion) have helped shore up the balance of payments and translate capital inflows into accumulated reserves. But with oil prices hardening and domestic foreign exchange demands increasing substantially in the wake of the new round of liberalisation, it is likely that autonomous inflows of foreign exchange could prove inadequate to meet foreign exchange demands. India's external vulnerability, reduced because of a set of "unanticipated" benefits, is now once again on the rise, increasing the possibility of a financial crisis of the Southeast Asian kind. 
Thus, the qualitative change in the economic environment arises not because of new directions in reform, but because the rapid acceleration of the same old reform process is qualitatively changing the external environment facing the county. What is at issue s not a new "generation" of reforms, but the blind pursuit of a path that allows profligate use of foreign exchange with little concern for earning the wherewithal needed to meet the costs of pursuing that path. 
Does this mean that there is no generational shift in the reform process that is likely? It does not. One way in which such a shift is likely to occur is through a movement of the reform process from the Centre to the States. In India's quasi-federal system, there a host of economic decisions that are made or implemented at the State level. The process of economic "reform" or liberalisation affects the States of the Indian union in manifold ways. First, since reform has as its principal focus the liberalisation of trade, exposure to competition from abroad can adversely affect economic activities that are of importance to or even the mainstay of individual states. For example, the liberalisation of the edible oil trade and the trade in primary commodities has, in the recent period when international commodity prices have been on the decline, had damaging consequences on the incomes and livelihoods of sections in Kerala engaged in the production of a range of primary products. 
Second, the process of fiscal adjustment at the Centre has involved reductions in per unit food subsidies and substantial cuts or stagnation in social and capital expenditures, resulting in inadequate social sector services and virtually no progress on the poverty alleviation front. Most often, it is the government at the State level which has had to deal with the likely social consequences of these developments, reducing their manoeuvrability. 
Finally, with the recent reductions in interest rates on small savings instruments such as the PPF, it is likely that small savings collections, much of which goes to the States, would fall. In addition, the direct tax and excise duty concessions which have accompanied reform, have eroded the States' share in central taxes. This together with the refusal, till recently, of the centre to implement the new tax devolution principle (wherein 29 per cent of all tax revenues are transferred to the Sates) recommended by the Tenth Finance Commission, and accepted by the National Development Council meeting in July 1997, has involved a loss of revenues estimated at over Rs.4000 crore a year for the States. 
In partial response to this situation, and under pressure from allies in the National Democratic Alliance, the government has decided to implement the revised revenue sharing formula recommended by the Finance Commission and approved by the NDC. But by choosing to apply the 29 per cent-share principle to net rather than gross tax receipts, the Centre has retained almost 50 per cent of the States dues in its hands. This implies that despite the recent announcement the fiscal problems faced by the States would persist. 
There is enough evidence world-wide that a fiscal crunch, attributed to fiscal mismanagement, provides the basis for pressure to launch on economic reform. In India, without revealing the actual processes by which the fiscal crunch at the State level has been generated and without examining its relation to reform at the central level, the fiscal problems of the states have been attributed to fiscal mismanagement. In particular, the losses sustained by public sector corporations, the state electricity boards and the inadequate recovery of costs by departments providing irrigation, health and primary education, have provided the bases for explaining the fiscal crunch in full. 
This has led up to a wholly new way in which the wave of reform has begun to affect the States. In some cases, individual States have turned to organisations like the World Bank for sectoral lending and have in return been required to adopt a more comprehensive reform programme, involving above all else an across-the-board increase in user charges for public services, in order to restore fiscal health and build the capacity to meet the future repayment commitments associated with large scale sectoral lending. What therefore starts as a sectoral borrowing programme ends up being a larger State level structural adjustment programme involving a major restructuring of State finances. 
The response of individual States to this situation has varied. Some have gone ahead with the reform programme, as is true of Andhra Pradesh. Others have gone a part of the way or, like West Bengal, have resisted intervention by the Bretton Woods institutions. However, the protagonists of reform insist that an important component of "second generation reform" has to be Bretton Woods-style reform at the State level.
The implications of this for the cost of living in individual States, after they implement tariff hikes for public services, and for social expenditures, are obviously adverse. It is for this reason that many States are wary of treading the reform path. But if the fiscal squeeze on the States persists, many of them may be forced to accept far-reaching "reforms". In that event, India would have definitely entered a whole new phase in the reform process. In all probability, it is the effort to force such an outcome on the States that explains the hype surrounding what are being ambiguously termed "second generation reforms".

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reforms, economic reforms, second generation reform, insurance sector, Patents Act, quantitative restrictions, reducing tariffs, Tariff reduction, liberalisation of consumer goods imports, liberalization, Exim Policy, foreign direct investment, foreign equity holding, Foreign Investment Promotion Board, FIPB, foreign direct investment (FDI) through the automatic route, financial sector, financial sector controls, profit repatriation by foreign entities, ADRs, GDRs, External Commercial Borrowing, ECB, Bretton Woods twins, liberalisation, remittances from India workers abroad, balance of payments, liberalisation of trade, fiscal adjustment, food subsidies, social and capital expenditure, social sector services, poverty alleviation, small savings instruments, PPF, direct tax, excise duty concessions, tax devolution, Tenth Finance Commission, Finance Commission.

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