Basic statistics of India
The Indian economy has been catching up quickly in the past two decades, and weathered the global recession well, with only a limited and short-lived slowdown. In just over 11 years, income per capita has doubled. Wide-ranging reforms and increased investment have lifted potential growth to almost 9%, the highest in Indian history, helped by improvements in infrastructure. Inclusive growth of 10% per year is feasible given that demographic developments are set to push up saving, but will only be achieved if the administrative and regulatory barriers facing companies are reduced. In addition, the government should step up efforts to restructure public expenditure; reduce the fiscal deficit; relax some of the constraints facing the financial sector and further promote international integration. In the near term, the authorities need to remain vigilant against the risks of high inflation and volatile capital flows.
Assessment and recommendations
In recent years, the Indian economy has been catching up very quickly. Prior to the global recession, annual growth exceeded 9%, an unprecedented step up from already high growth rates in the early 2000s. The Indian share of global output has continued to rise and the productivity gap with OECD countries has shrunk, though it remains large. Private investment is a key driving force. It is supported by buoyant corporate sector profitability and a rising national saving rate, which has reached the levels East Asian economies achieved during their periods of rapid growth. Growth has been broad-based but large regional disparities endure.
Sustaining growth and improving living standards
India has enjoyed one of the highest growth rates in the world in recent years, propelled by strong business investment. India was not immune from the global financial crisis but experienced a relatively mild slowdown, despite a severe drought which hit agricultural production. The recovery was driven by strong domestic demand, supported by expansionary fiscal and monetary policy, and growth has returned to a high trajectory. Prudent macroeconomic policies will be critical to prolonging the current expansion, given risks surrounding inflation, which has been high, and volatile capital flows. A steadfast commitment to fiscal consolidation is needed to continue to reduce the large deficit that emerged in the aftermath of the slowdown. Continued structural reforms will also be necessary to maintain high growth over the longer term. The operating environment for private business remains challenging compared with many other countries. While infrastructure is improving in key sectors, partly thanks to greater private investment, bottlenecks threaten to constrain the economy and efforts to intensify competition and ensure continued strong investment are required. Rapid economic development has boosted living standards and reduced poverty but the number of Indians living in poverty remains high. There is a need to strengthen social welfare systems and access to health and education to ensure widespread benefits from continued high growth. Labour market reforms are also required to promote job creation.
Fiscal prospects and reforms
Substantial fiscal consolidation was achieved under the aegis of the 2003 Fiscal Responsibility and Budget Management Act. While deficits widened anew in 2008 and 2009, against the backdrop of the global financial and economic crisis, efforts to reduce them have resumed since. To ensure continued progress, as well as stronger government finances in the longer term, the medium-term fiscal framework needs to be improved, notably by embedding the annual budget in a detailed three-year rolling programme. Expenditure needs to be controlled better, in particular as regards subsidies, which the central government is indeed trying to rein in, though with difficulty in the face of rising world oil prices. Expenditure also needs to become more effective, in particular in the areas of health care, education and social assistance. On the revenue side, tax reforms have been tabled, both for direct taxes and for the complex and inefficient system of indirect taxes. Corporate income tax rates are being cut, though the headline rate remains high. Lower taxation for large special economic zones deserves to be maintained for some time. For the personal income tax, which only a fairly small proportion of the population pays, thresholds are set to be raised considerably. A goods and services tax is to be introduced, which should help reduce the segmentation of the national market for goods and services. Customs duties have been reduced on average but remain high for some categories of imports, implying scope for further reduction over time.
Phasing out energy subsidies
India’s energy subsidies are large by any standard and impose enormous fiscal costs on the central government and, in turn, on Indian taxpayers. They also entail economic and environmental costs and primarily benefit wealthier households. Phasing out energy subsidies and allowing greater latitude for price signals to operate in energy markets would increase economic efficiency and reduce greenhouse gas emissions over the long run. A number of steps have been taken recently in this direction, including a change in gasoline pricing, as well as efforts aiming at moving away from the current system of subsidies on kerosene and liquid petroleum gas towards direct help in cash for people with incomes below the poverty line. Higher world oil prices have overwhelmed these efforts, however. Targeted cash transfers would help shield low-income households from increases in energy prices though they will be difficult to implement effectively.
Financial reform in India: time for a second wave?
The Indian financial system has changed considerably since the 1990s. Interest rates have been deregulated and new entrants have been allowed in the banking and the securities business. The Indian equity market has become world-class, while new private banks have emerged that are more customer-oriented than the older state-owned banks. Meanwhile, the scale of saving within the economy has expanded considerably, much as in East Asian economies during their high-growth period. This adds to the need for further financial-sector reform. In particular, banks need much greater freedom in asset allocation. While public-sector banks did appear sounder to the public during the 2007-08 crisis due to implicit government backing, they ought to be privatised to improve their governance and minimise the recurrent need for recapitalisation. The remaining obstacles to new entry have to be reduced. Financial inclusion is an important priority and restrictions on microfinance should be avoided. The regulatory and legal framework also needs to be overhauled, consolidating the diverse legislation. While such reforms would improve financial sector efficiency they would also likely have positive spillover effects on the rest of the economy and help sustain rapid growth.
Building on progress in education
Education has been given high priority by India’s central and state governments and continues to grow fast. School access has been expanded by investment in school infrastructure and recruitment of teachers. In higher education too, the number of providers continues to rise rapidly. A new law enshrining the rights of all children to free and compulsory education will further lift enrolment, bringing closer the government’s goal of universal elementary education, which comprises eight years of schooling. Nevertheless, high drop-out rates and low attendance continues to be a challenge at lower levels and enrolment at higher levels remains modest by international standards. Private sector involvement is on the rise. While it helps expand education infrastructure, particularly in higher education, access has not always been assured and the availability of student loans for higher education needs to improve. Poor learning outcomes amongst school students and mediocre higher education provision call for more effective government regulation and funding arrangements. Expanding resources will help but they need to be deployed more effectively, while incentives and professional development systems for teachers need to be strengthened. In higher education the government has proposed reforms which have the potential to bring about much-needed improvements in regulatory effectiveness. Efforts should focus on reducing micro-regulation and improving institutional autonomy, in order to stimulate innovation and diversity. Increasing the number of institutions subjected to quality assessments will be important for lifting standards across the higher education system, while reform of recruitment and promotion mechanisms could help attract and retain talent in academia.
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