India Rising—Faster Growth, Lower Indebtedness

“Sharing Experience in Growth Analysis”

Brian Pinto

PRMED

The World Bank

October 10, 2007

• Based on a paper with Gaobo Pang and Marina Wes

[World Bank Policy Research WP 4241]

• Preliminary results from looking at firm investment behavior (using the Prowess Database) being done jointly with Taye Mengistae and Nan Geng

A growth resurgence• India now in its fifth year of rapid growth• Most remarkable feature: was unanticipated!• Why?

a. Could not be anticipated?b. Right kind of analysis not done?

• Answer is related to transition over the 1990s and in particular to the question:

How have high fiscal deficits and high growth coexisted for so long in India?

Answer: (a) true on average BUT serious ups and downs; (b) deterioration in public finances over 1997-2002 was

macro cost of post-1991 reforms; growth resurgence is lagged benefit from better micro foundations

Last 25 years:• Real GDP growth close to 6%• Yet, general government debt/GDP rose by 34

percentage points!– 48% of GDP in 1980/81

– 82% of GDP in 2005/06

• And no major crisis (when compared to other EMs)– But a BoP in 1991 which proved a critical turning point (as

we’ll see)

• Paper concentrates on post-1991

Hypotheses to Explain Coexistence

• Keynesian explanation, since no crisis after 1997– But growth fell as deficits rose 1997-2002

• Big infrastructure push raised short-run deficits and debt but raised growth with a lag– But big cuts in government capital expenditure after 1991

• Financial repression– Closed capital account

– Issue debt at artificially low interest rates

Buiter-Patel 2005

India solvent because:• High nominal GDP growth• Financial Repression

Hold it!!• Real GDP growth high too• Scope for financial repression down drastically

after mid-1990s

Let’s Look at Financial Repression (briefly)

• A big factor in late 1980s, early 1990s• Kletzer (2004) estimates FR revenues to be

negative in 2001 and 2002!• India much more open economy – gross flows

on CA and KA to GDP risen from $96 bn and 40% in 1992/93 to $506 bn and 71% of GDP in 2004/05 (Kelkar (2005)).

• Small savings – interest rates greater than the market

Public Finances & Growth • No satisfactory framework• Easterly (2005) on growth empirics: “…national policies that

have received the most attention are fiscal policy, inflation, black market premiums on FX, financial repression vs. financial development, real overvaluation of the exchange rate, and openness to trade.”

• Insufficient in at least three ways:– misses government’s intertemporal budget constraint– no cumulative, lagged effects allowed for– ignores micro-foundations of growth.

• No easy ways to model:– gradual reforms– long lags in response of firms and banks– endogeneity among fiscal deficits, debt and growth.

Our Explanation (Post 1991)

Reasons for high deficits and high growth overlap

• Big reform-induced revenue loss after 1991 from customs, excise and financial repression taxes

• These very factors plus lower entry barriers have increased competition and hardened budgets for firms and banks

• We know from firm-level studies in transition countries of CEE that the latter has a profound effect on the microfoundations of growth

The Big Picture

Eighth Plan

0

2

4

6

8

10

12

80/81 82/83 84/85 86/87 88/89 90/91 92/93 94/95 96/97 98/99 00/01 02/03 04/05

30

40

50

60

70

80

90

Debt stock Fiscal deficit Real GDP Growth

Fiscal deficitReal GDP growth

Debt stock

Eighth Plan (92/93-96/97)

Ninth Plan(97/98-01/02)

Tenth Plan(02/03-05/06)

Benchmark (85/86-89/90)

Figure 1 Growth (%), Fiscal Deficit, and Debt Stock (% of GDP)

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India

Key Ideas• Macro: 9th plan period outcomes

intensification of 8th plan period outcomes– Reject “8th plan good, 9th plan bad” stereotype – Reject “fiscal profligacy” argument

• Micro: serious restructuring began in 1996-97 (import competition began to bite)– Key dates:

• 1991: opening up and tax reforms begin• 1996-97: firm and bank restructuring starts• 2003: visible results.

Fundamental QWhat enabled such a long transition without a

crisis?– Slow approach to CAC and S-O banks

• Gradual loss of fin repression taxes

• Captive market for g-secs

– Debt tolerance• 1991 especially

• 1997-98: shift towards domestic debt and FX reserve build up after 1991 helped in “crisis” proofing

Table 1. Fiscal Adjustment 1985/86-2005/06(based on period averages)

Benchmark 85/86-89/90

First 4 years of 10th Plan versus

% of GDP

8th Plan versus

85/86-89/90

9th Plan versus

8th Plan 9th Plan 85/86-89/90

1. Revenues 19.4 -1.5 -1.0 +1.7 -0.8

2. Interest 3.8 +1.3 +0.6 +0.6 +2.6

3. Capital expenditure 6.6 -2.9 0.0 -0.3 -3.2

4. Net impact (3.+2.-1.) -- -0.1 +1.6 -1.4 +0.2

5. Non-interest current exp. 18.3 -1.9 +0.8 +0.2 -0.9

6. Impact on GFD (4.+5.) -- -2.0 +2.4 -1.2 -0.7

7. Primary deficit (3.+5.-1.) 5.4 -3.3 +1.8 -1.8 -3.3

8. Revenue deficit (2.+5.-1.) 2.6 +0.9 +2.4 -0.8 +2.5

Memo item: growth %/yr. 6.2 +0.3 -1.2 +1.9 +1.1

Note: Rounding off error present.Source: Authors’ calculations based on Handbook of Statistics on Indian Economy, Reserve Bank of India

Table 2. Factors Accounting for Rising Indebtedness, 1985/86-2005/06(Annual average, % points of GDP)

85/86-89/90

90/91-91/92

92/93-96/97

97/98-01/02

02/03-05/06

1. Increase in debt 3.5 3.6 -2.5 2.5 0.2 2. Primary Deficit 5.4 3.8 2.1 4.0 2.2 3. Real GDP growth -3.7 -2.4 -4.7 -3.6 -5.7 4. Real interest rate -0.3 -2.0 0.3 2.8 3.5 5. Real exchange rate change 0.2 1.9 0.1 0.3 -0.3 6. Financial Sector Recapitalization 0.0 0.0 0.3 0.0 0.1 7. Divestment 0.0 -0.2 -0.2 -0.1 -0.2

8. Residual (1. minus sum of 2. to 7.) 1.8 2.4 -0.4 -0.9 0.7

Source: Authors’ calculations based on Handbook of Statistics on Indian Economy, Reserve Bank of India

Table 3. Changing Indebtedness, first 4 years of 10th Plan period(% points of GDP)

2002/03 2003/04 2004/05 2005/06 1. Increase in debt 5.1 0.0 -2.1 -2.0 2. Primary Deficit 3.2 2.7 1.4 1.3 3. Real GDP growth -2.8 -6.6 -6.7 -6.7 4. Real interest rate 4.0 3.5 3.1 3.2 5. Real exchange rate change -0.3 -0.5 -0.3 0.1 6. Financial Sector Recapitalization 0.1 0.2 0.0 0.0 7. Divestment -0.1 -0.6 -0.1 -0.1

8. Residual (1. minus sum of 2. to 7.) 1.1 1.4 0.4 0.1

Source: Authors’ calculations based on Handbook of Statistics on Indian Economy, Reserve Bank of India

Our Explanation – 2Macro deterioration in debt dynamics in late 1990s:• Mainly because of tax losses and rise in interest payments, not

fiscal profligacy• Decline in taxes possibly exacerbated by slowing growth as

private investment pulls back after initial binge• Lagged effects of govt capex cuts on private investment

Micro transition has been slow and meandering:

• Reforms gradual, takes time to attain credible, critical mass• Learning and adaptation involved:

– Investment boom during early years of reform likely to have been of low quality

Three Stages in Micro Transition

• First stage – investment boom in early 1990s based on existing relationships instead of market fundamentals

• Second stage (1996-2003) restructuring of balance sheets and real assets

• Third stage – broad-based growth resurgence starting in 2003/04

Effective Customs Duty Rate (%)

Figure 2: Investment as a share of GDP, 1985–86 to 2004–05

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

1985-86 to1989-90

8th Plan 9th Plan 2002-03 2003-04 2004-05

Private Investment Government Capital Spending Gross Fixed Capital Formation

8th Plan period Investment surge[…] largely because neither industrialists nor

bankers had any experience in operating in liberalised environments, almost every project that was submitted for financing was accepted. [..] the system created capacity (which is quite possibly what showed up as growth numbers) in industry after industry – steel, man-made fibre, paper, cement, textiles, hotels, and automobiles received a major share of the large loans given principally by the DFIs and partly by the CBs.

--Mor at al. (2005)

1996 start of “serious restructuring”

It seems as if every Indian group .. invested in power, telecom and finance ventures in the 1993–95 period,.. where they usually had no background. ..only in the last four years as industrial growth has fallen and industry has come under the ..pressure of [import] competition ..and falling margins that firms have been forced to look at which activities they really wish to retain.

--Forbes (2002)

Tobin's Q for Companies in the Prowess Database

0

0.5

1

1.5

2

2.5

Year

Q

The movement in Q is consistent with our hypothesis

that• The opening up and tax reforms of the early 90s gave

an initial and short lived boost to corporate investment opportunities (1991-95)

• Sustained growth in capital stock could only follow the restructuring (and correction) phase of 1996-2003

• Signs are that the upturn in from 2002 onwards is going to be sustained for a while.

Real GDP growth at factor cost (%)

85/86 -89/90 (avg.)

8th Plan

(avg.)

9th Plan

(avg.)

10th Plan

02/03 -05/06 (avg.) 02/03 03/04 04/05 05/06

Agriculture, forestry & fishing 3.1 4.7 2.3 1.9 -6.9 10.0 0.7 3.9 Industry of which, manufacturing

7.6 7.8

7.6 9.8

3.4 1.2

8.0 7.7

7.0 6.8

7.6 7.1

8.6 8.1

8.7 9.0

Services 7.6 7.6 8.6 8.9 7.3 8.2 9.9 10.0 GDP 6.0 6.7 5.5 7.0 3.8 8.5 7.5 8.4

Source: Authors’ calculations based on Handbook of Statistics on Indian Economy, Reserve Bank of India

Growth rebound: Cyclical vs. Structural

• Excellent survey in Ouri (2007):– Medium-run g forecast at 8%– TFP g has gone up since 2003!– TFP g over 2003-05 more than double that over

1980-9 or 1990-99– (if you can believe the results)

• Took 12 years for the reforms which began in 1991 to yield tangible results.

Figure 5: India’s Export Performance (Rupees billion, constant prices)

0

500

1000

1500

2000

2500

3000

3500

1991-9

2

1992-9

3

1993-9

4

1994-9

5

1995-9

6

1996-9

7

1997-9

8

1998-9

9

1999-0

0

2000-0

1

2001-0

2

2002-0

3

2003-0

4

2004-0

5

A large part of this adjustment is that firms are becoming more and more export oriented

Exports as a ratio of corporate sales(Prowess database)

00.050.1

0.15

0.20.250.3

0.35

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

The Infrastructure Gap• Everyone agrees infrastructure (esp. in elec, roads,

urban) is the biggest constraint on continued rapid growth

• Then why not just borrow and fill the gap even if short-run deficits go up?

• Two reasons why not:– Investments required are huge, debt already high– Marginal financial ROR to govt (user charges plus higher

future taxes) may not be enough to recoup the marginal cost (Serven-Burnside 2006)--SEBs an example

• Thus, real possibility that government’s net worth could go down without accompanying reform

Growth rate needed to maintain debt-to-GDP with Rise in Capital Expenditure

2.02.53.03.54.04.55.05.56.06.57.0

1991

/9219

92/93

1993

/9419

94/95

1995

/9619

96/97

1997

/9819

98/99

1999

/0020

00/01

2001

/0220

02/03

2003

/0420

04/05

2005

/06

Actual Capital Exp. Counterfactual Capital Exp.

0

2

4

6

8

10

12

14

16

18

1991

/92

1992

/9319

93/94

1994

/95

1995

/96

1996

/9719

97/98

1998

/99

1999

/0020

00/01

2001

/02

2002

/03

2003

/0420

04/05

2005

/06

Actual growth Counterfactual growth

11.6%

6.5%

11.3%

5.4%7.3%

10.6%

Less Risky Option

Create fiscal space for infrastructure by:

1. Implementing fiscal reforms• Revenue adjustment• States’ fiscal adjustment• Subsidy reform (food, power, fertilizer = 3% of GDP)

2. Defining role for private sector while monitoring contingent liabilities

India’s Revenue AdjustmentKey point: big potential for raising revenues without

raising marginal tax rates (Poirson (2006))• Average Effective Tax Rates are low• AETR = Statutory tax rate X [Actual tax

base/Potential tax base]• GoI 2004 Road Map for FRBMA: Corporate tax

collections to go from 2.3% of GDP in 2003/04 to 4.2% in 2008/09 WHILE CIT rate goes down from 35% to 30%!

• VAT holds great potential too.

States’ Fiscal Adjustment

• 12th FC recommendations to play major role– Lower indebtedness

– Reform borrowing regime

– Eliminate revenue deficit by 2008/09

• VAT implementation key (revenue mobilization)• SEB losses a serious problem (off-budget)• With current trends in growth and interest rates,

simulations show TFC targets can be reached with a cross-sectoral program of state and center reforms

Summing UpOnce you take into account:• Macro-micro linkages• LagsYou come up with:• More positive interpretation of post 1997 macro

outcomes• Strong likelihood that growth surprise of past few

years is based on strong microfoundations and therefore durable

BUT infrastructure constraint remains. India is not yet out of the woods.

Lessons

• Rules of thumb on “prudent” debt-to-GDP levels of limited use

• India’s self-insurance after 1991 has echoes in other EMs post 2000. In all cases, public investment has been cut, fueling concerns about LR g

• Long lags may need to play out before it becomes obvious whether public debt is sustainable (indictment of unit root tests)- market myopia might derail the process

• India was helped by going slow on CAC and domestic financial liberalization.

Things needing further analysis

• Impact of cuts in cap exp

• Ways of closing the infrastructure gap and government’s role

• Likely response of states to 12th FC

• Micro restructuring in real and financial sector consequent upon 1991 reforms.

THANK YOU!