M Govinda Rao: Will the glitter last?

The Indian economy has continued its buoyant performance in the first half of 2005-06. GDP in the first quarter has accelerated to 8.1 per cent with strong manufacturing growth (12.1 per cent) and every observer is busy revising the GDP forecast for the year upwards to 7-7.5 per cent. With a near normal monsoon, agricultural revival is certain. The buoyant performance of the manufacturing sector continues, as seen from the trends in commercial credit. The services sector continues to perform well. Thus, the growth is all-round""in the primary, secondary, as well as services sectors.

The optimism is not confined to growth performance alone. Despite persisting fiscal imbalances and a steep increase in oil prices, there are no immediate dangers to macroeconomic stability. The RBI predicts the inflation rate to be 5 to 5.5 per cent for the year. Although interest rates may slightly harden with increasing commercial credit, overall it is likely to remain benign. Increasing oil prices may create a current account deficit of about 2 per cent of GDP during the year, but an increasing flow of invisibles will ensure comfortable external payments. The savings rate has reached 28 per cent of GDP in 2003-04, and in later years, further fiscal improvements must have enhanced it further. What is needed is a more efficient intermediation of savings into capital formation to increase it from the stagnant level of 23 per cent.

While the optimism in the present environment is natural, it would be inappropriate to ignore the risks. The persisting fiscal imbalance may worsen if the expected revenues are not realised and the competitive populism of coalition politics causes expenditure profligacy. Another major risk factor is infrastructure bottlenecks. The important sectors presenting binding constraints include power, transport, including ports, railways, and airports, and urban infrastructure. An important external shock that has added to the risk is the sharp increase in the international price of crude. When the effect of this works itself out, it could constrain manufacturing growth and increase the price level. The most worrisome issue is the difficult political environment for reforms.

The buoyant performance of the economy for the third consecutive year has raised expectations that the economy has accelerated to a higher growth trajectory. Many now feel that achieving 8 per cent growth during the Eleventh Plan period is no longer a dream. It has been suggested that there has been significant productivity growth in Indian manufacturing, and demographic as well as institutional factors support higher growth. Is this optimism well-founded? If it is, then it is a case of growth acceleration without reforms, which is nothing less than a miracle.

Unfortunately, such things do not happen. Even in the past, there were spurts in growth, but they were temporary. The growth of the agricultural sector continues to depend on monsoons and manufacturing growth has shown wide fluctuations since the middle of the 1990s. Since 1997-98, almost 70 per cent of the growth was contributed by the services sector, the sector in which liberalisation was effective. If the economy has to grow at 8 per cent during the Eleventh Plan, both agriculture and manufacturing should show better performance. Continued stagnation in agriculture will not only drag the overall performance of the economy but will also result in jobless growth and stagnation in the material living conditions of the majority of the people. Similarly, lasting performance in the manufacturing sector will require larger investments and increase in productivity.

It is important to understand that the sustained growth of the services sector was possible because the reforms have liberalised this sector. Accelerating growth and sustaining it in agriculture and manufacturing would require implementing reforms. Wide-ranging reforms to free the agricultural sector from the shackles of various controls on the movement and sale of products, increased investments in harnessing water resources in a sustainable manner, creating enabling conditions for contract farming through a promotional and regulatory framework, promoting agricultural extension, and ensuring adequate credit are some of the measures.

On the manufacturing side, reforms are required to make the sector competitive in the international market. This requires significant improvement in infrastructure through increased public investments, creating enabling conditions for public-private partnerships, and reforms to enhance productivity. In areas such as power supply and policy, institutional reforms will have to continue. Other important measures required include ensuring more flexible labour market conditions, further small-scale industry de-reservation and creating an enabling environment for attracting foreign direct investments. Indeed, excessive protection given to 7.5 per cent of the workforce has placed serious constraints on expanding employment opportunities for the rest.

Fiscal reforms are critical in accelerating growth. The Finance Commission has recommended a restructuring plan and the central government should show leadership in adhering to it. Reforms in the tax system are necessary not only to improve revenue productivity but also to remove microlevel inefficiencies. The important tax reforms include rolling back many of the exemptions and tax preferences, continued improvements in the tax administration and information system, and the levy of full-fledged VAT. The objective of the last measure should be to create an unhindered common marker in the country. A recent NIPFP study has shown that the annual cost of exemptions and concessions could be as high as Rs 48,000 crore.

Critical areas of infrastructure reforms include the railways, power, urban infrastructure, ports, and airports. The railways have been used to distribute political patronage by successive ministers, with little heed to commercial performance and reinvestment for renewal and expansion. The time has come to corporatise the sector and remove political control over it. Similarly, the monopoly status provided to the Airports Authority of India has done little to ensure adequate investments and performance in the sector.

These are only some of the important reforms needed to set the economy on a higher growth trajectory. If the reforms indicated above are implemented, the economy can grow consistently at 8 per cent, or even 10 per cent during the Eleventh Plan. The critical question is, whether the special interest groups will allow the reforms to be carried out, and will we be able to create an enabling environment to unleash creative energies to improve the living standards of the people?

The author is Director, National Institute of Public Finance and Policy. Comments at mgr@nipfp.org.in