Report No. 25797-IN India Sustaining Reform, Reducing Poverty July 14, 2003 Poverty Reduction and Economic Management Sector Unit South Asia Region A World Bank Development Policy Review CURRENCYAND EQUIVALENT CurrencyUnit =IndianRupee US$1-INR46.28 FISCAL YEAR April 1 -March 31 ACRONYMSAND ABBREVIATIONS ACR Annual Confidential Report GATS General Agreementon Trade in Services AD AntiDumping GCF Gross CapitalFormation AIDS Acquired Immune Deficiency Syndrome GDP Gross DomesticProduct AP AndhraPradesh Go1 Governmentof India APDRP AcceleratedPowerDevelopment and ReformProgram GSDP GrossStateDomesticProduct BE Budget Estimate HIV HumanImmunodeficiencyVirus BIFR Bureau of Industrialand Financial Restructuring HUDCO Housing and Urban Development Corporation BMC GreaterMumbai MunicipalCorporation ICAC HongKong's Independent Commission Against Corruption BOP Balance of Payments ICAR Indian Council of AgriculturalResearch BPL Below PovertyLine ICDS Integrated ChildDevelopment Service CAD CurrentAccount Deficit IDB India DevelopmentBond CAG Comptroller and Auditor General IDBI IndustrialDevelopmentBank of India CDS Current Daily Status IDFC InfrastructureFinance Development COmprnY CDW CurrentWeekly Status IFCI IndustrialFinancial Corporation of India CENVAT CentralValue Added Tax IMF InternationalMonetaryFund CII Confederationof Indian Industries IMD India MillenniumDeposit CIP CentralIssue Price IR Indian Railways CMIE Center forMonitoring Indian Economy IT InformationTechnology CPE CentralPublicEnterprises Kwh Kilowatthour cso CentralStatistical Organization LGED Local GovernmentEngineering Department css CentrallySponsored Schemes LIC Life Insurance Company DAP Di-Ammonia phosphate MDGs MillenniumDevelopmentGoals DCCB District Central Cooperative Bank MMR MaternalMortality Rate DM DistrictManager MOP Muriate of Potash EAIF EmergencyAfrica Infrastructure Fund MoF Ministryof Finance EAS EmploymentAssurance Scheme MOIC Ministryof Industry and Commerce EGS EmploymentGuarantee Scheme MoRD Ministryof Rural Development EIF EuropeanInvestmentFund MOU Memorandumof Understanding EPF EmployeeProvidentFund m.p. MarketPrice EPS EmployeePension Scheme MP Madhya Pradesh ERC ExpenditureReform Commission MRP Maximum Retail Price EUS EmploymentUnemployment Survey MRTP Monopoliesand RestrictiveTrade PracticesAct FDI Foreign Direct Investment MSP Minimum SupportPrice FC Finance Commission MTRF MediumTermReforms Facility f.c. Factor Cost MW Mega Watt FCI Food Corporation of India NACO National Aids ControlOrganization FICCI Federation of Indian Chambersof Commerceand NAFTA North American Free Trade Agreement Industry FRBM Fiscal Responsibilityand Budget Management Act NBFC Non-bank financial corporation NCDC National Cooperative Development Council RBI Reserve Bank of India NDDB National Dairy Development Board RCC Rural Credit Cooperative NER Net enrollment rate REC Regional Environment Center NFHS National Family Health Survey SBA Small Borrower Accounts NGO Non-Governmental Organizations SCB State Cooperative Bank NHDP National Highways Development Project SCARDB State Cooperative Agricultural and Rural Development Bank NIPFP National Institute of Public Finance and Policy SEB State Electricity Board NPA Non-performing asset SHG Self Help Group NPL Non-performing loan SICA Sick Industries Companies Act NRI Non Resident Indian SME Small and Medium Enterprise NSS National Sample Survey SPV Special Purpose Vehicle OECD Organization for Economic Cooperation and SPS Sanitary and Phytosanitary Development O&M Operations & Maintenance SSA Sarva Siksha Abhiyan (Education For All) p.a. Per Annum SSI Small Scale Industry PC Planning Commission TERI Tata Energy Research Institute PF Provident Fund TFP Total Factor Productivity PAC Public Account Committee TPDS Targeted Public Distribution System PAC Public Affairs Committee T&D Transmission and Distribution PDS Public Distribution System T&V Training and visit PEGF Pre-Export Guarantee Facility UP Uttar Pradesh PLR Prime Lending Rate UPS Usual Principal Status PMGY Prime Minister's Gramadaya Yojna (Rural UPSS Usual Principal and Subsidiary Status Electrification Program) PPP Public Private Partnership USO Universal Service Obligation PRG Partial Risk Guarantee UTI Unit Trust of India PROST Pension Reform Options Simulation Toolkit VAT Value Added Tax PSEDF Private Sector Energy Development Fund WPI Wholesale Price Index PWD Public Works Department WTO World Trade Organization QR Quantitative Restriction Vice President : Praful Patel, SARVP Country Director : Michael F. Carter, SACIN Sector Director : Sadiq Ahmed, SASPR Sector Manager : Ijaz Nabi, SASPR Task Managers : Mark Baird, Consultant & Manuela Ferro, SASPR ACKNOWLEDGEMENTS This report was prepared by a team led by Mark Baird and Manuela Ferro, under the overall guidance o f Sadiq Ahmed and Michael Carter, and with advice from Stephen Howes and Ijaz Nabi. The peer reviewers were Nick Stem, Shankar Acharya, Suman Bery, and Pranab Bardhan. Major contributors to the report were Brian Pinto and Farah Zahir on fiscal policy, Robert Beschel and Vikram Chand on civil service reform, Jeffrey Hammer on human development, Priya Basu on the investment climate for industry and services, Dina Umali-Deininger on agriculture and rural development, Bhavna Bhatia on the power sector, James Hanson on the financial sector, Anthony Bottrill on the extemal sector, Luis Constantino on decentralization, Esperanza Lasagabaster on pensions, Gloria Kessler on the environment, and Gamy Purse11 on trade policy. A background paper on fiscal management was prepared by National Institute o f Public Finance and Policy (NIPFP) in New Delhi. Bhaskar Naidu and KrutiBharucha provided statistical support. Administrative support was provided by Shunalini Sarkar and Shahnaz Rana. The DPR team visited India inFebruary 2003 and receivedvaluable comments on the draft report from the Government o f India inJune 2003. INDIA: SUSTAININGREFORM. REDUCINGPOVERTY TABLE OF CONTENTS EXECUTIVE SUMMARY......................................................................................................................... i PART I:ASSESSMENT OF DEVELOPMENT OUTCOMES............................................................. 1 Overview ................................................................................................................................... 1 Poverty Outcomes and Economic Performance........................................................................ 2 Social Outcomes........................................................................................................................ 7 Economic and Social Outcomes: A Regional Perspective........................................................ 8 Accelerating Development inIndia: Goals and Policy Agenda ................................................ 9 PART11:POLICY AGENDA:MANAGINGPUBLICRESOURCES.............................................. 11 I1 1:FISCAL POLICY............................................................................................................................ . 12 Introduction............................................................................................................................. 12 Government Debt Dynamics and External Vulnerability ....................................................... 15 Government Debt Dynamics ............................................................................................ 16 External Vulnerability ...................................................................................................... 17 Costs o fthe Fiscal Stance........................................................................................................ 18 Fiscal ReformPriorities .......................................................................................................... 21 Tax Ref0rm....................................................................................................................... 21 Subsidy Reduction............................................................................................................ 21 Financial Policy ................................................................................................................ 23 FiscalManagement........................................................................................................... 25 Government Debt Projections: Why Fiscal Adjustment? ....................................................... 26 I1 2: DELIVERY OFPUBLICSERVICES.......................................................................................... . 31 Introduction............................................................................................................................. 31 Civil Service Reform............................................................................................................... 31 Size and Structure o f the Civil Service............................................................................. 31 Costs o f the Civil Service ................................................................................................. 32 The Return on Civil Service Expenditures ....................................................................... 34 Improving Public Service Delivery .................................................................................. 35 Health, Educationand Social Safety Nets............................................................................... 37 Health Strategy and Policy Priorities................................................................................ 40 Education Strategy and Policy Priorities .......................................................................... 43 Providing Effective Social Safety Nets ............................................................................ 45 Towards the Future ................................................................................................................. 46 PART111:POLICY AGENDA: IMPROVINGTHEINVESTMENT CLIMATE............................ 47 I11 1:INDUSTRYAND SERVICES...................................................................................................... . 48 Performance: Achievements and Challenges.......................................................................... 48 Investment Climate: Key Constraints and Policy Priorities.................................................... 50 ProductMarket Distortions............................................................................................... 50 Factor Market Distortions................................................................................................. Infkastructure Bottlenecks................................................................................................. 56 59 Estimated Impact o f a Better Investment Climate on Overall Economic Performance ..........63 111 2: AGRICULTURE AND RURALDEVELOPMENT.................................................................. . 64 Agriculture and the Rural Economy........................................................................................ 64 Foodgrain (Rice and Wheat) Policy........................................................................................ 67 InputPolicies........................................................................................................................... 68 Fertilizer Policy ................................................................................................................ 68 Water Resources and Irrigation........................................................................................ 69 Power Supply to Agriculture ............................................................................................ 70 Product and Factor Markets .................................................................................................... 72 Trade Policies and Regulations ........................................................................................ 72 Access to Land.................................................................................................................. 73 Access to Rural Credit ...................................................................................................... 75 Enhancing the Productivity o f Public Investments ................................................................. 76 Agricultural Research and Extension ............................................................................... 76 Rural Roads ...................................................................................................................... 77 Rural Electrification.......................................................................................................... 78 PART1%':DEVELOPMENTPROSPECTSAND RISKS................................................................... 79 Outlook.................................................................................................................................... 79 Risks........................................................................................................................................ 82 Conclusion............................................................................................................................... 83 REFERENCES......................................................................................................................................... 85 STATISTICALANNEX .......................................................................................................................... 96 Tables Table 1: Progress on Social Indicators. 1980-2000 .................................................................................. i Table 2: Macroeconomic Trends over the Past Two Decades ................................................................ ii Table 3: Ratio o f Average Wages inthe Public and Private Sector ...................................................... vii Table 4: Absence Rates from Primary Facilities, 2003 .......................................................................... ix Table 5: Custom DutyRates inIndia and Other Developing Counties ................................................ xi Table 6: Macroeconomic Projections -Baseline and Reform Scenarios............................................ xvii Table 1.1: Macroeconomic Trends over the Past Two Decades ................................................................ 3 Table 1.2: Sectoral Shares o f GDP, 1980/81 and 2001/02......................................................................... 4 Table 1.3: Unemployment Rates, India and Comparator Countries........................................................... 6 Table 1.4: All India Social Indicators, 1980-2000 ..................................................................................... 7 Table 1.5: Concentration o f Poverty inIndia ............................................................................................. 8 Table 2.1: General Government Fiscal Trends......................................................................................... 12 Table 2.2: Trends inCentral Govemment Finances................................................................................. 13 Table 2.3: Trends in State Government Finances .................................................................................... 14 Table 2.4: K e y Macroeconomic Aggregates ............................................................................................ 16 Table 2.5: Sustainable and Desirable Deficits inthe Tenth Plan Context................................................ 19 Table 2.6: Government Subsidies ............................................................................................................ 22 Table 2.7: Fiscal Projections .................................................................................................................... 29 Table 2.8: Ratio o f Civil Service Salary and Dearness Allowance to GDP for Go1and Selected States......................................................................................................................... 32 Table 2.9: Ratio o f Average Wages inthe Public and Private Sector for Selected Categories o f Employment ............................................................................................................................ 32 Table 2.10: Absence Rates from Primary Facilities inSelected States. 2003 ............................................ 39 Table 2.11: Health Spending inIndia and Comparator Countries ............................................................. 41 Table 2.12: Education Spending inIndia and Comparator Countries ........................................................ 43 Table 3.1: GDP. Industryand Services Growth Rates ............................................................................. Table 3.2: Un-weighted Average Customs DutyRates inIndia and other Developing Countries ..........48 53 Table 3.3: Indirect Tax Rates in Selected Developing Countries............................................................. 56 Table 3.4: GDP, Agriculture Sector Growth Rates .................................................................................. 65 Table 3.5: Recent Fertilizer Policy Reforms............................................................................................ 69 Table 3.6: Go1Major Domestic Policy and Trade Regulations, January 2003 ........................................ 72 Table 4.1: Macroeconomic Projections Baseline and Reform Scenarios .............................................. 80 Table 4.2: Elasticity o f Employment to GDP, 1993/94 - 1999/00, Selected Sectors .............................. - 81 Figures Figure 1: General Govt.Deficit and Debt Stock 1985/86 2002/03 ...................................................... ... . 111 Figure 2: Government Debt/GDP Ratio Projected to 2006/07 ................................................................ vi Figure 1.1. Per Capita Income Trends -India and Comparator Countries ................................................. 1 Figure 1.2: Poverty and Per Capita Income Trends, 1983-1999/00 ............................................................ 2 Figure 1.3: UnemploymentRates (Current Weekly Status), 1987/88-1999/00 ........................................... 6 Figure 1.4: State-Wise Per Capita Income. 3 year average (1998/99 -2000/0 1)........................................ 9 Figure 2.1: General Government Deficit and Debt Stock 1985/86 - 2002/03 .......................................... 12 Figure2.2: Primary Deficits andthe ImpliedDifference between the Real Rate o fInterest and Growth.............................................................................................................................. 17 Figure 2.3: Gross Capital FormationinPrivate and Corporate Sector and the General Government Deficit including Oil Pool ................................................................................. 19 Figure 2.4: Real Interest Rates (1990/91-2001/02) .................................................................................... 20 Figure2.5: Government Debt/GDPRatio Projected to 2006/07 ............................................................... 28 Figure 2.6: Projected General Government Fiscal Deficits ....................................................................... Figure 2.7: Public Expenditures on Education(center and states, inbillion rupees at 1993 prices) .........28 Figure 2.8: Public Expenditures on Health (center and states, inbillion rupees at 1993 prices)...............38 38 Figure 2.9: Prevalence o f Diseases by Income Group: All India, 1992 .................................................... 42 Figure 3.1: Private Investment inIndustry and Services, (annual average growth rate) ........................... 48 Figure 3.2: State-Level Industrial Growth, by State, 1990-99................................................................... 50 Figure 3.3: Bankruptciesas a Share o f Total Firms................................................................................... 58 Figure 3.4: Cost o f Power.......................................................................................................................... 60 Figure 3.5: Energy Costs as Share o fTotal Sales...................................................................................... 60 Figure 3.6: Shipping and Cost Disadvantages inTextiles ......................................................................... Figure 3.7: Gross Capital Formation inAgriculture and Allied Sectors, Rs.billion, 1993/94...................62 66 Figure 3.8: Electric PumpsOnly: Irrigation Cost as a Percent o f Gross FarmIncome in Haryana................................................................................................................................... 71 Figure 3.9: Percentage Distribution o fNumber o f Owned Holdings and Area Owned by Farm Size.......................................................................................................................................... 73 Boxes Box 1: Who are India's Poor?............................................................................................................... ii Box 2: UrgentNeedfor Reforms inPower Distribution...................................................................... v Box 3: Summary o f Priority Reforms ................................................................................................ xix Box 1.1: Who are India's Poor?............................................................................................................... 2 Box 1.2: India's Success inInformation Technology(1T) ....................................................................... 5 Box 1.3: Targets for the Tenth Planand Beyond................................................................................... 10 Box 2.1: Assumptions UnderlyingDebtDeficit Projections................................................................. 27 Box 2.2: Karnataka's Lok Ayukta ......................................................................................................... 37 Box 2.3 Buildinga Healthy Environment............................................................................................ ,42 Box 3.1: Key Structural Reforms since 1991........................................................................................ 52 Box 3.2: Damaging the Land................................................................................................................. 66 Box 4.1: Summary o f Priority Reforms................................................................................................. 84 Statistical Annex Table A l : Gross Domestic Expenditure and Product (shares based on current price data) Table A2: Gross Domestic Expenditure and Product (Rs. billion current prices) Table A3: Annual Growth Rates o f National Income and Product at Constant Prices (annual growth rates) Table A4: Gross Domestic Product by Expenditure, National Income and Savings (Rs. billion at 1993-94 prices) Table A5: Exchange Rates and Prices Table A6: Central Government Finances Summary Table A7: Budgetary Classification o f Central Government Finances Table A8: Budgetary Classification o f State Government Finances TableA9: Budgetary Classification o f General GovernmentFinances Table A10: Transfers BetweenCenter and States Table A11: Outstanding Debt(Center and States) Table A12: Banking Survey and Interest Rates Table A13: Balance o f Payments Table A14: Exports and Imports Table A15: External Debtand Debt Service Table A16: Financial Sector Indicators Table A17: InvestmentClimate Table A18: Vulnerability Indicators Table A20: Development Indicators- India and Comparator Countries Table A19: Millennium Development Goals Indicators Table A21: Unemployment Rates: Alternative Measures INDIA: SUSTAININGREFORM,REDUCINGPOVERTY EXECUTIVE SUMMARY Assessment of DevelopmentOutcomes 1. India has continued to make good progress in increasing incomes and improving living standards over the past decade. After the setback associated with the 1991 balance o f payments crisis, economic growth picked up, income poverty has continued to decline, and many social indicators, inparticular literacy, have continued to improve (Table 1). These developments were supported by the wide-ranging reforms launched in 1991 to open and deregulate the economy. Even though the pace of reforms has slowed since the mid-l990s, cumulative changes so far have been substantial. More sectors have been opened to private activity, trade policy and the exchange rate regime have been further liberalized, and capital markets have been reformed, leadingto an improved investment climate. Table 1: Progress on Social indicators, 1980-2000 1980s 1990s 2000 Poverty Poverty incidence (%) 44.5 36.0 26.1 Adjusted poverty incidence (%) 28.6 Education Overall literacy rate: 7+ years (%) 44 52 65 Female literacy rate as a percent of male literacy rate (%) 53 61 71 Net enrollment rate (NER):grades 1-5 (%) 47 51 77 Female NER as a percent of male NER: grades 1-5 (%) 70 80 81 Health Life expectancy at birth (years) 56 60 61 Infant mortality rate 0-4 years (per 1000 live births) 115 79 68 Maternal mortality rate (per 100,000) n.a. 424 540 Prevalence of HIV (million people) n.a. 3.5 4.0 Sanitation Access to improved water resources (%) n.a. 68 78 Number of households with toilet facility (%) n.a. 30 36 2. Development progress has been steady, but uneven. It has been uneven across indicators o f living standards, with notable progress in some areas, but little or no progress in others. Maternal and under-five mortality, for instance, has hardly improved, while the new threat o f HIV/AIDS is spreading quickly. And unemployment, although still low by international standards, has increased. Progress has also been uneven across regions. There i s evidence o f divergence in per capita incomes across states, with richer states increasing incomes faster than poorer ones. As a result, poverty has become increasingly concentrated in the country's slower growing states (Box 1). i Box 1: Who are India's Poor? Poverty i s pervasive in India. It i s present in the country's rapidly growing cities and vast rural areas. But it i s increasingly concentrated in the country's lagging states and rural areas. Over half o f India's poor now live in one o f four states: Bihar, Madhya Pradesh, Orissa, and Uttar Pradesh. Over two thirds live in rural areas. Inrural areas, the poverty incidence i s highest amongst agricultural workers, many o f whom are small-scale farmers or casual laborers. People o f scheduled castes and scheduled tribes are far more likely to be poor than those o f other social groups, as low- caste status and gender barriers still operate as social obstacles that block or exclude them from opportunity. India's poor suffer not only from lower incomes, but also from lower access to and quality o f public services, such as basic health, education, and infrastructure. The poor often lack the leverage to ensure that state institutions serve them fairly and must often pay for education and health services that others receive for free. For example, studies by India's Public Affairs Center indicate that the wealthy and middle classes are more likely to resolve their complaints at a lower cost. Corruption is often a highly regressive tax and the poor pay more o f their incomes proportionately than do the wealthy and the middle class. 3. Recent growth trends also give reason for concern (Table 2). Economic growth slowed from an annual average o f 6.7% over the five years from 1992/93 to 1996/97, to 5.5% from 1997/98 to 2001/02. Continued strong growth inthe services sector was offset by a slowdown in industrial growth and a marked decline inagricultural performance. Growth slowed further to an estimated 4.4% in2002/03, due to the impact of poor rains on agncultural output inseveral states. Table 2: Macroeconomic Trends Over the Past Two Decades 1980s 1990s 1992193-1996197 1997198-2001102 2002103 GDP growth (% per annum) 5.6 5.8 6.7 5.5 4.4 Agriculture 3.4 3.0 4.7 1.8 -3.1 Industry 7.0 5.8 7.6 4.5 6.1 Services 6.9 7.6 7.5 8.1 7.1 Investment rate (% of GDP) 22.0 23.0 23.3 22.5 22.1 Public 10.0 7.8 8.0 6.6 6.3 Private 12.1 15.2 15.3 15.9 15.7 Inflation (WPI, % per annum) 8.0 8.1 8.7 4.9 2.5 General government deficit (% of GDP) 8.1 7.8 7.2 9.3 10.4 Current account balance (% of GDP) -2.1 -1.4 -1.2 -0.7 1.o External reserves (months of goods and services 3.3 5.6 5.9 7.0 11.0 imports, end of period) 4. The recent growth deceleration was accompanied by a slowdown in investment, especially in the private sector. Firms invested and borrowed heavily inthe mid-l990s, building capacity for an expected demand based on continued high growth rates, and assuming continued reforms would generate highreturns. Inthe meantime, trade reforms left some sectors more open to competition, while facing "behind the border" constraints to improved productivity. As the pace o f reforms slowed, interest rates rose, and the expected demand failed to materialize, many firms found themselves saddled with excess capacity and debt. 5. The fiscal position o f the general government (center plus states) also deteriorated over this period. The overall budget deficit rose from around 7% in 1997/98 to more than 10% by 2002/03, due to a significant increase in government consumption and continued low revenue mobilization. Higher public debt and higher interest rates also added to the debt service burden. 11 As a result, resources available for public investment became increasingly constrained, with adverse consequences for infrastructure development. 6. At the same time, prudent monetary policy has helpedto contain inflation and strengthen the balance o f payments. Rapid growth o f IT service exports, sluggish domestic demand for imports, and higher remittances turned the current account balance into surplus. Together with modest capital inflows, this has generated a substantial increase in external reserves, which now exceed US$80 billion, equivalent to almost one year o f imports. 7. With one-third o f the world's poor and over one billion people, India needs rapid growth to reduce poverty and create enough jobs to sustain income increases for its population. In its Tenth Five-Year Plan, the Government o f India (GoI) targets an average growth rate o f 8% per annum for 2002/03 to 2006/07. However, there are macroeconomic vulnerabilities and structural impediments that limit India's prospects for accelerating growth and reducing poverty, as the Tenth Plan and the most recent Economic Survey recognize. India's development policy challenges can be grouped into two broad areas: (a) improving the management o f public resources, by reducing budget deficits, reallocating spending to more productive investments, and enhancing the quality o f service delivery; and (b) improving the investment climate and raising productivity inindustry, services, agriculture and rural development. Policy Agenda: Managing Public Resources Fiscal Policy 8. As shown in Figure 1, the general government (center plus states) fiscal deficit has averaged more than 9% o f GDP over the past six years (NinthPlanplus 2002/03). About 60% o f this deficit is at the center and 40% at the state level, where Figure 1: General Govt. Deficit and Debt Stock much o f the recent (% GDP) 1985/86-2002/03 deterioration in the fiscal - 90.0 situation has occurred. Of 11.0 - particular concern i s the sharp - 80.0 increase in revenue deficits, - 70.0 which have more than doubled from less than 3% in - 60.0 the late 1980sto average more 6.0 - - 50.0 than 6% o f GDP over the past six years. This trend reflects 3:: falling revenues and rising 5.0 4.0 85/86 87/88 89/90 91/92 93/94 95/96 97/98 99/00 01/02 expenditures on interest payments, subsidies, civil --.E)--.FiscalDeficit/GDP - + - DebtStock/GDP service salaries and pensions, administration and defense. In turn, this has crowded out development spending, with negative implications for long-run growth and welfare. 9. These fiscal deficits have largely been financed by borrowing, with a strategic shift towards long-tenn rupee debt after the 1991 crisis. General government debt rose from 58% o f GDP at the end o f March 1986 to 85% o f GDP by the end o f March 2003 (Figure 1). Including debt o f public enterprises, total public debt i s now 95% o f GDP, with contingent liabilities from loss-malung public enterprises adding another 12% o f GDP. With high primary deficits (more than 3% o f GDP) and interest rates close to growth rates, the burden o f public debt i s expected to continue rising -- unless there i s a concerted effort to adjust the fiscal position o f the center and state governments, ina progressive and phasedmanner over the next few years. ... 111 10. On the surface, these fiscal indicators are worse than those faced by India in 1991- and worse than inmany other countries that actually suffered a macroeconomic crisis. However, the risko f crisis inIndia today is mitigatedby the country's strong external position. Risingexternal reserves, and low levels o f short-term external debt, give the country a very comfortable cushion to counter any speculative attack. The risk o f a speculative attack i s further reduced by a pliant financial system (which i s willing to hold large amounts o f domestic government debt), limited capital account convertibility, and a flexible exchange rate. Thus India i s not vulnerable in the short term to the type o f collapse suffered by Russia or Argentina. 11. Even so, the Tenth Plan i s right to be concerned about the consequences over the medium term o f leaving the current fiscal situation unchecked. What has emerged in effect i s a mixture o f "loose fiscal, tight monetary" policy that has helped to keep inflation low and the external accounts strong. But this has been at the expense o f growth and welfare, as growing interest payments have crowded out public investment, and high real interest rates have constrained private investment. Even though interest rates have declined over the past 18 months, public debt dynamics have continued to worsen. 12. There i s a lively debate going on in India today as to whether the large fiscal deficit i s a serious problem or not, given the high levels o f external reserves and food stocks. Indeed, some see fiscal stimulus as desirable to counter the slowdown in private sector activity. However, arguments for fiscal stimulus are not convincing at a time when public debt levels are so highand interest rates may well start to rise from their current low levels. Furthermore, to the extent that the recent increase in external reserves has reflected capital inflows dnven by one-off events related to September 11, 2001, it would be risky to slow fiscal reform on a gamble that such flows will continue indefinitely. Nor would it be prudent to assume that India can simply grow out o f its fiscal problem. On the contrary, analysis presented in the Tenth Plan suggests that a sizeable fiscal adjustment will be required to generate the level o f public savings, and provide space for the level o f public and private investment, needed to generate 8% growth. 13. Based on this analysis, fiscal reforms are needed inthe following areas: 0 Tax reform. The Tenth Plan targets an increase in tax revenues from 8.1% o f GDP in 2001/02 to 10.3% o f GDP by 2006/07. Achieving this goal rests on several key assumptions, including a strong recovery in manufacturing sector growth (as this sector has the highest tax buoyancy) and extending the tax base to the booming services sector. The Kelkar Committee reports on direct and indirect taxes essentially endorse the above approach, requiring that lower tax rates be complemented with the elimination o f exemptions, bringing services and agriculture into the tax net, and using information technology to improve tax administration. These reforms deserve the highest priority in view o f the substantial decline in the tax ratio during the 1990s and the positive impact higher tax effort would have on reducingprimary and revenue deficits inthe future. 0 Subsidies. Financial losses o f the power sector reached an alarming Rs.332 billion in 2001/02, or 1.4% o f GDP. Recent studies show that the poor do not benefit from cheap electricity, either inurban or rural areas, providing little social justification for continued SEB losses. Therefore, the financial and social case for reform i s strong. Proposed reforms in power distribution are summarized in Box 2. Similarly, food and fertilizer subsidies totaled Rs.352 billion in 2002/03, or 1.4% o f GDP. These subsidies have distorted farmer cropping and investment decisions, and thereby contributed to natural resource degradation. Proposals for reforms in these areas, and for reallocating funds to more productivity-enhancing public investments, are outlined in the section on agriculture and rural development below. Petroleum subsidies, which totaled Rs.63 billion in2002103, or 0.3% o f GDP, are also to be phased out over the medium term. iv Box 2: Urgent Need for Reforms in Power Distribution Reform o f power distribution is essential for both fiscal sustainability and spurring growth by providing more efficient supply and quality of power services to industry, farmers and rural areas. Under the framework of the new Electricity Act (2003), reformsare urgentlyneededinthe following areas: (a) Tariffs: Ensuringthat tariffs on average cover costs and yeld a reasonablerate of return for the utility, and that regulatorysystems have suitable mechanismsand sufficient independenceto assurethis over time. Achieving phasedbut time-boundreductionof the cross subsidy paidby industriesand services, and improving cost recovery throughconsumption-basedtariffs charged to agricultureandresidentialconsumers. (b) Subsidies: Ensuringthat where, for policy reasons, the government wishes to subsidize power, subsidies are clearly delineated, targeted and funded, within fiscally sustainable levels. Developing alternativemechanismsto deliver subsidies while enabling the utilities to operate on a commercial basis. Moving from present flat-rate tariffs to consumption-basedtariffs for agriculturewater pumping. (c) Restructuring, commercializationand sector governance: Separating SEBs into generation, transmission anddistributionbusinesses; andensuringthat the unbundledutilities haveindependentboards, financial autonomy, and skilled management with full control over operations and labor force. ReducingT&D losses, including theft, andimproving operational andmanagerialefficiencyinpower distributionandsupply. (d) Distribution privatization: Acceleratingprivatizationof the commercially-viablesegments of the distribution business to lock in the gains from improved operational and managerial efficiencies on a sustainable basis. Targetinga broaderrange ofpotentialinvestors andactivelymitigating the perceivedpolicy andregulatoryrisks. (e) Strategies for rural areas: Developing approaches to shift from the present form of subsidy for electricity consumption to innovative models of provision of capital subsidy for improving access in rural areas and for the poor. Facilitatingnew entry for timely andcost effectiveprovisionof electricity services. (0 Competition: Opening up electricity trading by industries with self generation, along with other power suppliers, by providing open access to transmission and distribution networks in a phased manner along with eliminationof cross subsidiesduringan agreedtime frame. 0 Financial sector. Indian banks have one o f the highest ratios o f government debt to deposits in the world. Financial institutions (including insurance and provident funds) which have invested heavily in long-term government paper have been making trading profits as interest rates continued to fall, but now face risks from the possibility o f rising interest rates. Moreover, state provident funds have also investedheavily inbonds issued by special purpose vehicles and guaranteed by state governments. The growing risk that these guarantees will be called i s reflected in the widening spread on state guaranteed bonds relative to central government securities. It's therefore encouraging to note that both the RBI and Go1are working on establishing a clear and transparent framework for guarantees. Returns on provident funds and small savings should also be linked to market benchmarks. 0 Fiscal management. The central government needs to lead by example, by cutting its own revenue deficits and providing the right incentives for fiscal adjustment at the state level. Fiscal discipline at the center i s likely be reinforced (but not guaranteed) by the new Fiscal Responsibility and Budget Management Bill, which mandates the elimination o f the center's revenue deficit by March 2008. Three states have passed similar Acts to limit their own deficits, and others are following suit. In addition, the center can help improve fiscal management at the state level by: (a) enforcing global caps on borrowing (both on-budget borrowing and off-budget borrowing through special-purpose vehicles); (b) simplifying the borrowing regime for states by allowing them to borrow responsibly from markets within their global gaps while phasing out borrowing from captive sources; (c) further expanding the volume o f center-to-state transfers linked to reforms and performance; (d) breaking down artificial distinctions between plan and non-plan expenditures; and (e) consolidating Centrally Sponsored Schemes, with greater flexibility for states to allocate the funds according to their own needs and priorities. V 14. The government debt projections presented in Part 11.2, and summarized in Figure 2, illustrate the importance o f generating primary fiscal surpluses to stabilize or reduce the debtIGDP ratio. Without reforms, the debt/GDP ratio continues to rise to 107% by the Figure2: GovemmentDebtlGDPRatio Projectedto 2006107 end o f the Tenth Plan period. 110.0, Under the reform scenario, with lower primary deficits (falling to 0.7% o f GDP by 2006/07) and higher economic growth (rising to 8% in 2006/07), the debt/GDP ratio i s brought down to 95%. With lower interest payments and subsidies, the reform 2002103 m3iW m105 2o05106 2036107 scenario also frees up more resources for spending on -+Basecase -A- Reform case priority programs (including O&M, social services and basic infrastructure). Both o f these trends - lower primary deficits and better expenditure composition -wouldbe good for growthandpovertyreduction. Without reform, the risks ofcrisis would steadily buildwith higher and less sustainable debt levels over the medium term. Delivery of Public Services 15. Sustained growth i s the most powerful driver of poverty reduction. Butpoverty reduction also requires investment in human development. Health and education are the most important assets o f the poor, allowing them to both contribute to and benefit from growth through higher- paying employment. In addition, when incomes fall below minimum standards, the poor and vulnerable need access to effective social safety nets. Delivery o f social services requires increasing the level, but more importantly the quality of public expenditures in these areas. This in tum requires improving the governance and productivity of India's civil service. On the positive side, a variety of refoms are already being implemented at the center, state and local levels, which could be quickly scaled up and disseminated across the country. There i s also a growing social demand for good governance. These developments present a real opportunity to raise the performance o f the civil service and enhance service delivery. The key i s to pushahead withimplementation. 16. Interms of aggregate numbers, the Indiancivil service is notparticularly overstaffed in comparison with other countries. However, there i s a pronounced imbalance in skills mix. Staff profiles need to be revisited to reduce the number o f administrative and support personnel (particularly at lower grades) and increase the number o f staff involved in front-line service delivery, including rural schools and health clinics. Inaddition, reforms are needed to reduce the fragmentation o f bureaucratic structures and responsibilities. Such reforms would help to improve coordination, shorten delivery times, and generate overall efficiency gains. 17. There i s also a pressing problem o f affordability. The FifthPay Commission awards in 1996/97 significantly increased spending on civil service wages, especially at the state level. Beyond the fiscal burden, these highsalary awards are questionable since the public sector i s now paying a substantial premium to the private sector in many job categories (Table 3). Recent experience would suggest it may be wise to hold off on the practice o f holding periodic pay commissions. Instead, Go1and state govemments could opt for limited annual wage increases, or even pursue a freeze for 2-3 years, followed by a limited relaxation for skilled positions. Alternatively, a permanent pay commission could be established to continuously analyze and vi make recommendations Table 3: Ratio of Average Wages in the Public and Private Sector on compensation, in consultation with the SelectedOccupations 1993194 1999100 states. Whatever system i s adopted, greater Professional,technicians and relatedworkers 1.52 1.72 weight should be given Engineers 1.07 1.34 to local market Engineeringtechnicians 1.3 1.27 comparators in Physiciansand surgeons 1.65 2.0 determining salary Nurses 2.0 2.0 levels. Teachers 1.75 2.02 Administrative,executive and managerialworkers 1.26 1.42 18. The costs o f the Clerical and related workers 1.6 1.74 civil service are raised Stenographers,typists, etc. 1.69 2.14 further by burgeoning Generalclerks (receptionist,office attendants,etc.) 1.54 1.72 pension liabilities at both Serviceworkers 2.25 2.45 the center and state Sweepers,cleaners, buildingcaretakers 1.79 1.93 levels. Inresponse, Go1 All 1.92 2.33 recently announced a plan to establish a fully- funded defined contribution scheme for new civil servants. This will force the payment o f pension liabilities as they accrue, creating a more transparent and financially viable scheme. However, since this reform will apply only to new civil servants, it will only contain pension costs over the longer term. Indeed, in the short to medium term, fiscal outlays may rise, as Go1 has to meet the combined costs o f the old and new schemes. Further reforms may therefore be needed, including changes in eligibility criteria, a possible shift o f younger civil servants to the new plan, and opening up o f the new scheme to private sector workers. These reforms could well serve as a model for the states to reform their own pension plans, and set a benchmark for reforming other pension schemes (including the Employee Provident Fund and the Employee Pension Scheme) over the mediumterm. 19. As a general rule, recent wage gains were not compensated by any commensurate increase inthe overall quantity and quality o f government services. To the extent that qualitative improvements have been made, they have often reliedheavily upon the application o f information technology to streamline and re-engineer business processes. However, even when IT has made many functions redundant, civil servants and powerful unions have often extracted pledges o f no job losses as the price o f allowing the innovations to go ahead. As a result, many line departments find themselves in an increasingly precarious position, with a growing proportion o f their non-plan resources being taken up by salaries, over which they have very limited control. Another hndamental problem haunting India's civil service i s the failure to use staff that it has productively. As a result, the cost structure o f many government functions i s significantly higher than inthe private sector. 20. The burden o f weak administration falls particularly heavily on the poor, who suffer in terms of skewed government spending, limited access to services, and employee indifference. Therefore civil service reform i s an essential element o f any poverty reduction program. An effective program o f civil service reform will have to include measures to achieve the following three objectives: 0 Improve access to information. Citizens' charters are one vehicle to empower the public in their dealings with service providers. It is important, however, that such charters be developed in consultation with major stakeholders and widely disseminated. NGOs can also play a vital role in collecting raw data, transforming it into usable information, and disseminating it to a wider audience. Several states are actively using vii IT to improve access to information and speed up decision malung. While there is evidence that computerization by itself seems to have an important effect on reducing corruption, the most successful initiatives combine computerization with extensive business re-engineering. Finally, Go1 and a number o f states are promoting greater transparency by adopting Rightto Informationlegislation. 0 Strengthen accountability. Internalaudit procedures needto be strengthened, with clear sanctions for corrupt or incompetent officers. However, the key i s to strengthen "extemal" accountability to the public. The recent experience o f the L o k Ayukta (Ombudsman) in Karnataka seems to be generating good results. Independence and adequate budgets are keys to the success o f such initiatives. Inaddition, a comprehensive anti-corruption strategy should include: (a) a radical overhaul and simplification o f the procedures for imposing major and minor penalties; (b) expanded "whistleblower" protection; and (c) publication o f property and tax returns o f senior officials. Each state should be asked to pass the Corrupt Public Servants (Forfeiture o f Property) Act, which has already been drafted by the Law Commission. 0 Reduce political interference. This topic i s a sensitive one, for the right to transfer civil servants i s clearly vested within the political leadership under Article 310 o f the Constitution. Yet few would disagree that this power i s often abused by both civil servants and politicians. The net result in states such as Uttar Pradesh has been a reduction o f average tenure for key senior service positions to less than a year. Compounding this problem has been the relative absence o f effective transition mechanisms. Recent successful reform efforts show the value o f having an empowered and dedicated manager in place for several years. Kamataka has gone one step further and limitedcivil service transfers, with transfer data postedon a public website and more objective cadre management committees created to approve transfer requests. 21. Weaknesses in service delivery are o f special concern in the social sectors: education, health and social safety nets. While India has made substantial progress towards achieving better social indicators over the past two decades, the rates o f improvement have not been sufficient to achieve the targets set in the Tenth Plan or even the less ambitious Millenium Development Goals (MDGs). Indeed, progress in health indicators has been slowing down precipitously. 22. Public spending on health and education in India has risen over the past decade, largely due to the sharp increase in wages awarded by the Fifth Pay Commission in 1997. International comparisons suggest that India's spending on health and education i s in line with other countries at similar income levels (although with a more dominant role for the private sector in health, and a more skewed distribution o f public spending in education towards the secondary and tertiary levels). While additional funding would help, better outcomes depend crucially on improving the quality o f services. As one indication, absentee rates for teachers and medical providers are very highinIndia, especially inthe poorer states (Table 4). Since absentee workers are on the payroll, it is not surprisingthat public money does not translate directly into better outcomes. 23. The root cause o f poor quality services i s that governments are not adequately focused on social outcomes. One way to increase the focus on outcomes i s to generate and disseminate information regarding progress in service delivery. Parents, patients and beneficiaries should know what they are entitled to and have a place to lodge complaints when they are not received. Providers and policy makers should know (and be constantly learning) about what works. One critical role o f the central govemment, when states have the primary responsibility for health and education, is to be an independent source for measuring outcomes. Over time, such measures viii could be used to hold states accountable for improvements - perhaps by conditioning fiscal transfers on progress. Table 4: Absence Rates from Primary Facilities, 2003 24. There are two (in %) deep problems in the health sector: a lack o f Primary School Teachers Primary Health Care Workers realism concerning the Andhra Pradesh 31 n.a public sector's role in the Assam 31 58 health system; and a lack Bihar 26 58 o f prioritization of the Gujarat 21 52 public sector's possible Havana 19 35 contribution. Most health Karnataka 23 43 care i s now given in the Kerala 18 n.a private sector and, for the Orissa 14 35 poor, by very poorly Or Punjab 18 n.a untrained practitioners. Rajastha,, 23 39 However, there i s no way Tamil Nadu 17 n.a to expand free publicly- supplied medical care to Uttar pradesh 26 42 Uttarancha, replace these private 25 45 West practitioners. Rather, the 21 43 government should aim to improve the private market, by providing training, public information and accreditation; over time, public financing o f private provision could be increased. Government programs should focus on ways to improve health outcomes, includingprograms outside the health sector (e.g., for clean water and sanitation). Within the health sector, the highest priority for public funds i s to combat communicable diseases. Disease control has large externalities and disproportionately benefits the poor. Relative to medical care, most o f these activities are also much easier to administer. The largest emerging problem in communicable disease control i s the increase in HIVinfections and cases ofAIDS. While estimates vary, there is no dispute that the infection is spreading rapidly. The primary focus o f policy should be on prevention. There are many competing needs for public health infrastructure, and it i s important that HIV/AIDS programs neither undercut resources to deal with killers like tuberculosis, malaria and diarrhea, nor get marginalized. 25. Progress in education has been much greater than in health. This reflects the greater opportunities for communities and parents to monitor and evaluate school performance as compared to health facilities. Nevertheless, there are large variations across states and income groups, and overall progress i s insufficient to attain the Tenth Plan goals. To accelerate progress inelementary education, Go1has launched the Sarva Siksha Abhiyan (SSA, or Educationfor All) program. It aims at providing eight years o f schooling for children in the 6-14 age group by 2010. Achieving this goal, which i s also formalized in the 93rdConstitutional Amendment, will require both additional public resources and improvementsinhow they are used. Making schools more accountable to the community i s critical, possibly as far as giving parents the right to hire and fire teachers through local school committees (as has been tried in Madhya Pradesh). Localities must be allowed the freedom to find their best solutions, while higher levels o f government provide measurement o f attendance, learning outcomes and other information needed to evaluate progress. 26. Many observers o f Indian administration have argued that decentralization and local empowerment will ultimately be essential in improving the quality o f service delivery at the village level. The most visible achievement of the 73rdand 74' Amendments to the Constitution, ix ratified in 1992, has been the high degree o f political decentralization. However, progress on fiscal and administrative aspects o f decentralization has been much more modest and hesitant. In response, India now needs to move from the decentralized patchwork it has created, towards an inter-governmental fkamework which leads to improved service delivery without increasing fiscal pressures. Good fiscal management would suggest reallocating public funds from central and state schemes into a well-designed fiscal framework for local governments, that would guarantee their autonomy and accountability, while helping them to match resource allocations with local preferences. It would also suggest creating incentives for local governments to collect a share o f their revenues from local taxpayers (e.g., through landtaxes). Flows o f funds from the center and state governments should be dependent on good performance and resource mobilization at the local level. PolicyAgenda: Improvingthe InvestmentClimate Industry and Services 27. A wide range of structural reforms stimulated industrial and services growth and investment inthe early 1990s. However, momentum inthe industrial sector slowed inthe second half o f the decade. Withinthe industrial sector, the slowdown inmanufacturing growth has been even more marked. Despite recent signs o f recovery, the manufacturing sector in India still accounts for only 17% o f GDP, compared to 35% in China and 25-35% inthe South East Asian economies. Furthermore, no significant increase in India's penetration o f world markets in industrial products has been observed over the past decade and foreign direct investment (as a share o f GDP) i s lower than in China and many emerging markets. As a result o f these trends, growth in manufacturing employment has averaged only about 2% per annum since the mid- 1990s, with most o f this growth in the unorganized sector. The organized manufacturing sector provides only about 7 millionjobs today. By comparison, the total labor force inIndia i s around 406 million, with a little under one million workers transitioning out o f agnculture every year. 28. Against this background, the Tenth Plan calls for higher growth inthe industrial sector to create 100 million or so newjobs over the next decade. The Plan notes that sustained industrial growth and employment will require a step up in domestic investment, particularly private investment, coupled with improved productivity. International comparisons indicate that India has intrinsic advantages, such as a large local market and skilled workforce, which should allow the country to emerge as a major hub for manufacturingand labor-intensive service industries. At the same time, recent studies on the investment climate show that the performance o f India's industrial and service sectors continues to be constrained by three key sets o f factors: (a) product market distortions; (b) inefficiencies in factor markets; and (c) infi-astructure bottlenecks. The success with which India can achieve the ambitious targets set in the Tenth Plan will depend crucially on progress inthese areas. 29. Product market distortions. Inadequate follow-through on a number o f key reforms to create a level-playing field for investment, both domestic and foreign, coupled with slow progress in trade policy reforms continue to inhibit industrial sector performance. Tariff protection in India i s still substantially higher than in most other developing countries (Table 5). The government has many well justified concerns about the policies o f other countries which restrict i t s exports, and it i s one of the most active developing countries in raising these concerns in international fora, such as the WTO. While India has some bargaining leverage to gain concessions fkom other countries, it should also use the WTO process to advance domestic reforms and protect them from local pressure groups. Inparticular, the government should move aggressively to reduce import tariffs to a single rate (say, 10%) over the next three to four years and phase out remaining tariff exemptions, specific tariffs and anti-dumping duties. It should also remove other productmarket distortions by: (a) eliminating the remainingpreferential policies for X small-scale players; (b) reducing indirect tax distortions by full and uniform implementation o f the new VAT across states; and (c) phasing out remaining limits on FDI (including the ban on FDIintheretail sector). 30. While the "License Raj" has been largely eliminated at the center, it still survives at the state level, along with a pervasive "Inspector Raj". Starting a business in India requires 10 permits compared to 6 inChina, and the median time is 90 days inIndia compared to 30 days in China. Complaints o f delays, corruption and harassment are common. To reduce the costs o f investment related to delays and rent seeking, all procedures for entry and exit o f firms needto be simplified and expedited, for example through the introduction o f "single window" clearances. Table 5: Custom Duty Rates in India and Other Developing Countries All goods Agriculture Manufacturing India 2001102(CD only) 32.3 41.7 30.8 India 2002103(CD only) 29 40.6 27.4 India 2002103(CD+SAD: estimate) 35 47.1 33.3 India 2003104(CDcSAD:estimate) 32.7 46.8 30.7 Pakistan2001102 20.4 21.8 20.2 Pakistan2002103(estimate) 18.2 13.9 18.3 Brazil2000 14.1 12.9 14.3 China 2000 16.3 16.5 16.2 Indonesia2000 8.4 6.3 8.9 Thailand 2000 16.6 39.9 14.6 South Korea 2000 12.7 47.9 6.6 105developing countries (1996-2000) 13.4 17.4 12.7 Notes: Un-weighted average rates. CD=Customs Duty, SAD=SpecialAdditional Duty 31. Inefficiencies in factor markets, coupled with a weak bankruptcy framework, have further constrained performance inthe industrial and services sectors: 0 Restrictions on the hiring and $ring of workers are identified as one o f greatest challenges o f doing business in India. Any registered firm wishing to retrench labor can only do so with the permissionof the state government, which i s rarely granted. Go1has recently announced its intention to raise the limit for seehng permission from 100 to 300 workers. However, to become effective, this requires enactment o f legislative changes by parliament. Go1should also consider amending the Contract Labor Act to allow the use o f contract labor for all activities -notjust for activities o f a temporary nature. 0 High real interest rates are often cited as another major impediment to industrial performance in India. Large, creditworthy borrowers have benefited from the recent decline in interest rates. However, the lack o f access to adequate, timely credit on competitive terms continues to constrain the development o f SMEs. Inresponse, banks should make efforts to introduce new technologies for S M E credit and also to train and motivate branch managers to provide loans to commercially viable SMEs. Go1can help by facilitating the establishment o f well-functioning credit information bureaudcredit registries for small borrowers, updating land and property records for small loans, and promoting collateral substitutes. 0 Problems with the use and transfer o f land also critically affect the perfonnance o f larger firms. Indeed, some 90% o f land parcels in India are reportedly subject to disputes over ownership, which take decades to settle in court. Furthermore, obsolete tenancy and rent xi control laws keep a large part o f urbanreal estate o f f the market. The central government has already abolished the Urban Land Ceiling Act which made changes in land use very difficult. However, only a few states have repealed their corresponding Urban Land Ceiling Acts. 0 Outdated bankruptcy procedures have, in the past, made industrial restructuring almost impossible. This may change, once the recently enacted Amendments to the Companies Act are put into effect. These will provide a framework for liquidating firms outside the court process. However, repeal o f the Sick Industries Companies Act i s essential for this framework to become effective. The recently passed law on the enforcement o f creditors' rights should also help accelerate the process o f industrialrestructuring. 32. Severe infrastructure bottlenecks continue to constrain India's industrial sector performance. Access to reliable power at reasonable costs i s a prime concern for most Indian businesses. N o t only does industryreceive irregular and low quality power, but it i s also charged tariffs much above the cost o f supply, reducing firm-level competitiveness. As a result, a large majority o f Indian firms operate their own (captive) generators, worsening utility finances. Small industries often have to go without power as they can't afford captive generation. Power sector reforms are n o w widely accepted as fundamental to improving industrial performance. An urgent priority i s the need to rationalize power tariffs, depoliticize the tariff-setting process, and implement a phased reduction in cross subsidies that operate against industrial consumers. Time- of-day tariffs need to be introduced for industries with peak and off-peak rates. 33. The above measures need to be accompanied by steps to improve the financial and operational performance o f the power utilities through the unbundlingand commercialization o f SEBs, independent regulation and improved sector governance. Privatization should be accelerated to lock in improved operational and managerial efficiencies on a sustainable basis. The strategy for privatizing distribution should consider focusing on the commercially viable segments o f the network, while developing alternate strategies for improving services and targeting subsidies inrural areas. The new Electricity Act (2003) establishes the legal framework for power sector reform and restructuring. But the key will be implementation. Go1can support reforms at the state level by imposing rigorous policies on payments to central generation and transmission utilities, and rewarding progress on reducing SEB losses and improving governance under the Accelerated Power Development and ReformProgram. 34. Speedy, reliable door-to-door transport sewices are also critical to India's manufacturing competitiveness. India has one o f the most extensive transport systems in the world. However, the sector suffers from severe capacity and quality constraints. The Tenth Planproposes a number o f road upgrading programs totaling 1O,OOOkm, along with access-controlled expressways in high-volume corridors. Meeting the Tenth Plan targets will require a significant increase in fundingfrom the private sector. Inpart, this can be addressed through better cost recovery from users. Much can also be gained in the short to medium term by strengthening the financial performance and accountability o froad agencies and state public works departments. 35. Indian Railways (IR) continues to be a patient who resists any bitter medicines, despite plenty o f prescriptions available. It has recently entered into operating deficits and depends on central budget for its large investment program. Reforming this sector will require large-scale financial restructuring, involving the shedding (or even ring-fencing) o f its non-core assets or businesses. Govemment policy also needs to address price distortions resulting from the long practice o f cross subsidization from freight to passenger services, which causes excessively high freight tariffs, preventing IR from serving the non-bulk high-margin transport market. In the ports sector, total berthcapacity i s no longer a serious constraint. However, the low productivity xii o f port equipment and labor continues to cause delays intumaround and increase costs for cargo and containers, especially inthe older ports. 36. Go1i s keen to promote greater private sector participationinthe provision and funding o f infrastructure. In the long run, this requires action to address the policy problems that underlie investors' concems by raising prices to cost-covering levels and establishing a sound legal and regulatory framework. In the short run, various public-private partnerships involving subsidies, risk-bearing and other forms o f government assistance may help attract private investment and close financing gaps. However, they can also risk simply postponing the day o f reckoning, and impose serious costs on taxpayers. Therefore, they should be seen, at best, as temporary measures and should be entered into with caution. Agriculture and Rural Development 37. Promoting more rapid agricultural and rural growth i s a major priority for the Government o f India. Although agriculture contributes only about a quarter o f total GDP today, its importance in the economic, social and political fabric o f India i s far greater than this number suggests. About 75% o f India's poor live in rural areas and a large proportion o f the rural poor are dependent on agriculture for employment. Total factor productivity in agriculture declined between the 1980s and 1990s due to the slowdown inproductivity gains from the earlier adoption of high-yielding varieties, the decline in public investments in the agtlculture sector, and increasing natural resource degradation due to the existing incentive framework. Loolung forward, improved agricultural performance will require: (a) rebalancing government expenditures from subsidies towards more productivity-enhancing public investments; and (b) removing the remaining restrictions on domestic trade to improve the investment climate for farmers, while supporting a regulatory framework to ensure fair competition. Development o f the non-farm sector will also be essential to provide employment opportunities in rural areas, and support growth o f the agricultural sector. 38. The government's foodgrain policy has led to mounting buffer stocks and food subsidies in recent years. In response, Go1 established a high-level committee to develop a long-term foodgrain policy with the primary goal o f maintaining self sufficiency. The committee's proposals to remove the rice levy and all restrictions on foodgrain trade (except in emergency conditions) will improve incentives for the private sector. However, other key proposals raise concems. In particular, the shift in the underlyingprinciple o f the proposed policy from food security to self-sufficiency, that also ties farmers to low value rice and wheat production, will come at the cost of efficiency. The continued large role envisioned for the public sector in foodgrain markets will crowd out private sector participation. And the reversion back to an untargeted public distribution scheme i s likely to bring back the earlier problems o f subsidies being capturedbynon-poor families and will result inhigher food subsidies. 39. Perhaps the most contentious issue in foodgrain policy i s the Minimum Support Price (MSP) for rice and wheat. Steady increases in the MSP in recent years have encouraged increasedproduction, leading to larger government procurement. Strong political pressure from states where the largest procurement takes place has stalled efforts by Go1to contain increases in the MSP. Therefore, the committee's proposal to limit the MSP to cover cash costs plus the retums to family labor, land and capital i s a step in the right direction. In the longer run, however, fostering competitive markets would serve as a better avenue for ensuring remunerative retumsto farmers. Inthis scenario, the MSP should be reduced to cover cash costs only, which complemented by other schemes (e.g., TPDS, employment schemes) would serve as a safety net for farmers. 40. The government's agricultural policy of the last three decades has relied on subsidizing key inputsto promote more rapid production growth and ensure food security for its population. xiii However, there i s also broad recognition that the rapidly rising subsidy levels are fiscally unsustainable and are crowding out productivity-enhancing public investments in rural infrastructure, irrigation, and technology upgrading. Power and water subsidies, to the extent they encourage inefficient water use, are also leading to salinity, water logging, and declining groundwater tables inmany areas. And fertilizer subsidies, that are largely concentrated on urea, have distorted inputuse. Sectoral priorities are as follows: 0 Fertilizer. In 2001/02, the government announced its policy to rationalize fertilizer pricing and to implement the recommendations o f the Expenditure Reforms Commission for a phased program o f price increases and complete decontrol o f urea by April 2006. Since then, a number o f reform actions have been implemented. Continued commitment to the proposed timetable will lead to a significant reduction in fertilizer subsidies over the next few years. 0 Water. The government's national water policy promotes the adoption o f a comprehensive and integrated approach to planning and managing water resources. It puts priority on: (a) delivery o f good quality water services; (b) demand-driven investments in rehabilitation and maintenance o f infrastructure through greater participation o f users in managing systems; and (c) cost recovery o f at least O&M costs to ensure longer-term financial and fiscal sustainability o f operations. To encourage full adoption o f these reforms at the state level, Go1recently introduced an incentive program to encourage recovery o f O&M costs. 0 Power. The large subsidy on the price of electricity to farmers has contributed to the severe financial crises o f SEBs. This in turn undermined the SEBs' ability to undertake requiredinvestments and maintain day-to-day operations, resultingin deteriorating power services to consumers, including farmers. The incidence o f subsidies i s also heavily regressive. India should move towards a more transparent and targeted subsidy mechanism. For this to work, it i s indispensable that there i s recovery o f at least operating costs, universal metering o f consumption, payment discipline, and improved delivery efficiency o f electricity providers. 41. Product and factor markets. While progress ineconomic and trade reforms has helped to improve the incentive framework for agriculture over the past decade, the sector i s still hampered by the continuing over-regulation o f domestic trading activities for major agricultural commodities. On the positive side, Go1 has temporarily lifted several key regulations such as storage, transport and credit control inrecent years. However, the over-hang o f their possible re- introduction discourages both local and foreign investments. Moreover, while Go1 has lifted these regulations, some state governments have not lifted the associated state controls. This inevitably raises marketing margins, putting downward pressure on farm prices and raising costs to consumers, while reducing the competitiveness o f exports. 42. Agricultural import tariffs have increased in recent years to an un-weighted average (including the Special Additional Duty) o f about 47%, compared to an average non-agricultural import tariff o f about 3 1%. With a few exceptions, India i s no longer explicitly taxing or using licensing, export bans or quotas as it did inthe past to deliberately restrict agricultural exports and depress domestic prices. However, since 2001 it has been exporting stocks o f rice and wheat accumulated by F C I at prices far below prevailing domestic prices. It i s questionable whether these subsidized exports are in India's long-term interests in a more open international agricultural market. India should also consider reducing its WTO agricultural tariff bindings, mostly now at 100% or more, as a way o f providing an external constraint on domestic lobbies pressingfor hightariffs. xiv 43. Access to land. The distribution o f land ownership inIndiahas become less skewed since the 1970s, with an increasing share owned by marginal to semi-medium farmers. The trend towards landlessness has also been arrested. However, regulations aimed at increasing security tenure for tenants have had unintended adverse effects, leading to large-scale self cultivation by landlords or the adoption o f wage labor contracts. Where their implementation was incomplete, they may also reduce land access and equity. There i s now a growing consensus, as reflected ina number o f government policy statements, about the need to revisit and re-formulate current tenancy legislations. In considering tenancy reform, it would be critical to draw lessons from states who do not have tenancy restrictions. There are some states where the benefits from relaxing tenancy laws are likely to be higher than in others, due to the more advanced commercialization o f agriculture (and significant amounts o f informal leasing) and stronger political commitment to reform. These states could serve as a starting point for pilots, and yield important insightsfor policy debate and tenancy reforms inother states. 44. The Department o f Land Resources introduced a scheme in the mid-1990s to pilot computerization o f land records in selected districts nationwide. Some states have not only scaled up the program statewide, but also implemented the program in partnership with the private sector. These initiatives have reportedly contributed to more efficient and rapid service as well as reduced opportunities for corruption through increased transparency. Over the longer term, the focus will have to shift towards a more holistic approach to improving land administration systems at the state level. To be successful, the land administration system would have to meet several other key standards o f performance, including security, costs, fairness, and sustainability. 45. Access to rural credit. India has a wide network o f rural finance institutions, but a large number o f the rural poor remain under-served or completely left out o f the formal financial system. A key factor constraining improved access to rural credit relates to inefficiencies inthe formal rural finance institutions. The government should aim to improve the performance o f the regional rural banks and the rural credit cooperatives by enhancing regulatory oversight and supervision, reducing government control and ownership, and strengthening the legal framework for loanrecovery and the use o f land for collateral. Other priorities for improving access to rural credit include: (a) liberalizing interest rates by removing the existing "cap" for small loans (that has the perverse effect o frationing credit available to small ruralborrowers); (b) improving credit information on rural households, by designating an agency that could take the lead in collecting and disseminating information on micro borrowers; (c) facilitating the scaling-up and sustainability o f existing low-cost micro-finance models, such as the self-help group bank linkage model and the Grameen bank replicators; and (d) removing legal and regulatory obstacles to the development o f innovations that can help reduce the costs and risks associated with rural finance. 46. Increased emphasis on productivity-enhancinginvestments will be critical to raising agricultural growth and developing the rural non-farm sector. However, to be effective, new investments need to be matched by improvements in the quality o f public spending, particularly a greater focus on O&M, which also involves significant institutional reforms. If anything, the growth rate i s likely to slow down over time, as the deteriorating fiscal situation and the sluggish progress on the reform agenda worsen the investment climate. Sectoral priorities are as follows: 0 India's public agricultural research and extension system i s one o f the largest in the world. However, over time, the efficiency and effectiveness o f these services have been increasingly called into question. There i s a need for a more regionally-differentiated research strategy, and greater coordination between the public and private sectors. Similarly, the top-down, narrow crop-focused approach to agricultural extension has become outmoded and ineffective in meeting the needs o f farmers. In the future, the xv public extension system will need to become more demand-driven, with stronger synergies between public and private extension efforts. 0 Most government programs for rural roads are designed to address the immediate rural accessibility problem, without a carefully-designed policy and institutional framework to ensure the sustainability o f these investments. Additional funds should be allocated for rural road maintenance, with greater coordination provided by the Ministry o f Rural Development. Community participation offers significant potential for mobilizing local support for resource generation, land acquisition and tailoring o f rural road programs to local needs. 0 India's rural electrification program has inthe past focused on extending the gnd supply to villages and remote areas. However, access by rural households remains low and power-based economic activities in the electrified villages i s minimal. Go1 plans to accelerate the rural electrification program over the coming decade. This needs to be matched by a more conducive policy environment, with adequate incentives for service providers and more effective targeting o f subsidies to poorer farmers and rural consumers. Decentralized generation should be encouraged, as reforms are put in place to privatize the commercially viable parts o f the sector. Development Prospects and Risks 47. Continued progress on poverty reduction will require both higher growth and improved delivery o f health, water, sanitation and education services. Many o f these goals are reflectedin the Tenth Plan, which projects an average growth rate o f 8% per annum and rapid progress across a range o f social indicators. However, the plan period started with a deceleration o f growth to an estimated 4.4% in 2002/03. Some o f the deceleration was due to external factors, including the impact o f flooding in some areas, and drought in many others, on agricultural output. While some recovery in growth i s expected in 2003/04, as the external environment improves, this bounce back i s unlikely to be sustained - without a major pushto reinvigorate the reform agenda. In the absence of major external or domestic shocks, current policies in India are likely to translate into a continued growth slowdown, averaging around 5% per annum over the Tenth Plan period (Table 6). xvi Table 6: Macroeconomic Projections Baseline and Reform Scenarios - Ninth Plan BaselineScenario ReformScenario 1997198-2001102 2002103-2006107 2002103-2006107 Real GDP growth at factor cost (% per annum) 5.5 5.0 6.5 Agriculture, forestry andfishing 1.8 1.5 2.2 Industry 4.5 5.3 7.1 Services 8.1 6.4 8.0 Investment (% of GDP) 22.5 20.5 27.7 Public 6.6 6.4 7.3 of which: generalgovernment 3.1 3.0 3.7 Private 15.9 14.1 20.4 Consumption (% of GDP) 78.8 80.5 73.5 Public 12.5 12.0 12.4 Private 66.3 68.5 61.I General Government(% of GDP) Fiscal deficit 9.3 11.8 10.3 Primary deficit 3.5 3.6 2.2 48. On the other hand, implementation o f a comprehensive reformprogram (as summarized inBox 3) would allow India to achieve a growth rate o f 8% per annumby the end of the Tenth Plan period, with positive impacts on employment and poverty reduction. Reforms to reduce fiscal imbalances at the center and in the states would create space for increased private investment. Improvements in the composition o f expenditure, with relatively less spending on civil servants' wages and pensions, subsidies and interest payments, and a shift towards O&M and investments in key infrastructure, would further "crowd in" private investment. Improvementsinthe investment climate, through the removal o f remainingbottlenecks inproduct and factor markets, and inkey infrastructure areas, would increase the productivity o f bothpublic and private investment across the economy, including inIndia's poor rural areas. More effective delivery o f health and education services, as well as social safety nets, would help accelerate social progress, empowering India's citizens to both contribute and benefit from faster economic growth. 49. Accelerating growth and poverty reduction in India cannot be achieved without also accelerating growth in India's lagging states. If the trends o f the past few years continue, the richer states would have to grow at nearly 10% per annum to reach an all-India average o f 6.5% duringthe Tenth Planperiod. This is rather unlikely. Therefore, implicit inthe envisagedreform scenario i s a special effort to correct fiscal imbalances, reallocate public resources to priority programs, improve public service delivery and strengthen the investment climate in lagging states. Primary responsibility for these reforms lies with the state governments. But the central govemment can also play an important role in catalyzing and setting the pace for reforms at the state level. 50. Of particular importance for poverty reduction and rural incomes are policies to increase agricultural productivity. In the short run, the removal o f subsidies to foodgrains could reduce agricultural output in a few states that benefit most from these subsidies. However, these are also states where significant agricultural diversification can take place. More importantly, this reform xvii would free up resources for agncultural research and development and rural infrastructure. Simultaneously, faster growth inindustryand continued rapid growth in services can providejobs for the labor force released from agriculture. 51. India's large fiscal imbalances pose a serious threat to sustained growth and development over the mediumterm. The persistence o f current fiscal trends will, at best, limit growth andjob creation. And slower growth would, in turn, speed up the deterioration indebt dynamics. Ifthis negative cycle continues, a full-fledged fiscal crisis cannot be ruled out over the medium term. Of course, it i s politically easy to downplay this risk,hoping that higher growth and lower interest rates will eventually solve the fiscal problem. However, experience suggests it would be unwise to sit back and wait for such a virtuous circle to emerge. Instead, the central and state governments will have to be pro-active in reducing the fiscal deficit, shifting expenditures into more productive areas, and removing structural impediments to higher private investment and productivity. The sooner the roadmap for these reforms i s put inplace, and concrete action taken to show commitment to follow through, the more manageable will be the adjustment path, and the quicker the pay-off interms o f higher growth and poverty reduction. 52. There are o f course other potential risks to implementing an ambitious reform agenda. Domestically, Indian politics are often distracted by general or state elections, and tensions with neighboring countries. Externally, the global recovery i s expected to be slow. While India i s still a relatively closed economy, and therefore somewhat protected from global trends, it does suffer from a loss o f market share to its major competitors, especially China, where reforms have moved ahead much more rapidly. And the inflow o f remittances into India and other countries in the region may well slow down, as the impact o f one-off events weakens. As a result, it would be r i s k y to gamble on the recent strength in the balance o f payments continuing and providing a counterweight to the deteriorating fiscal situation. 53, India canbe rightlyproud o f its development record over the past two decades. Itreflects the emergence o f a much wider consensus about the importance o f opening up the Indian economy to competition. The results in terms o f more rapid growth and poverty reduction are impressive. But India has still fallen behind its main competitors in East Asia - and poverty remains a reality for many Indians, especially those living in the poorer states o f the North and East. The government i s right to set ambitious targets for growth and social development during the Tenth Plan. The key now i s to implement the policy and institutional changes needed to achieve these goals. Sustained progress will no doubt be difficult, especially in the politically- charged areas o f labor, power and agricultural reform. But it also promises high returns for poverty reductioninIndia. xviii Box 3: Summary of Priority Reforms FiscalPolicy Progressivelyreduce the primary deficit at the center and in states by completingtax reforms (eliminating exemptions, bringing services into the tax net, and implementing a uniform state VAT), reducing power sector losses, andphasingout petroleumsubsidies. Reduce financial sector risks by implementing the new securitization law, linking retums on provident finds and small savings to market benchmarks, and establishing a clear framework for managing state govemment guarantees. Improvefiscal managementby imposinggreater fiscal disciplineon state borrowing andtransfers, breaking down artificial distinctionsbetweenplanandnon-planexpenditures, and consolidatingCentrallySponsored Schemes. Improve the compositionof public expenditures, by reducingthe share spent on wages, pensions, interest payments, and agriculturalsubsidies, andincreasinginvestment and O&M for priority social, infrastructure andagricultureprograms. Delivery of Public Services Reduce administrative fragmentation and reform civil service pay policy and pensions. Improve the performance of the civil service and quality of servicedelivery by improving public access to information, strengtheningaccountability,andreducingpolitical interference. Refocus health, educationandsocial safetynet programson outcomes. The centralgovemment canplay an importantrole as an independentsource for measuringprogresstowards agreedgoals. Improvethe private market for health care throughtraining, public information and accreditation. Priorities for public funds are to providecleanwater and sanitation, andto combat communicable diseases(including HIV/AIDS prevention). Support the SSA goals by providing increasedpublic resourcesand improving resource use in elementary education. Schools shouldbemore accountableto communities, with more local autonomyto find the best solutions. Developawell-designedfiscal framework for local govemments, that would guarantee their autonomy and accountability. Flows of funds from the center and states should be dependent on good local fiscal performanceandresource mobilization. InvestmentClimate for Industryand Services Speedup trade reformby reducingaverage import tariffs andphasingout tariff exemptions, specific tariffs and anti-dumpingduties. Remove other product market distortions by eliminating preferentialpolicies for small-scaleplayers, implementingafull anduniformVAT, andphasingout remainingFDIrestrictions. Reduce inefficiencies in factor markets by easing restrictions on hiring and firing of workers, improving SME access to credit, addressing problems in the use and transfer of land, and updating bankruptcy procedures. Ensure access to reliable power at reasonable costs by rationalizing power tariffs and improving the financial andoperationalperformanceof SEBs (Box 2). Address capacityandquality constraintsin the transport sector by improving public sector performance (for roads andrail), mobilizing private sector investment (including better cost recoveryfor roads), phasingout pricedistortions(for rail), and improvingthe efficiencyo f existing capacity(for ports). AgriculturalPolicy and Rural Development Put in place a market-basedfoodgrain policy which protects the poor through targeted safety nets, while mitigatingdrastic supply shocks through a cost effectiveandwell-managed price stabilizationmechanism. Reduceinput subsidieswhich are fiscally unsustainableanddistorting inputuse. Savings shouldbe usedto fund more productive investments in agricultural research and extension, rural roads, and rural electrification. Reduce regulation of domestic trading activities for major agricultural commodities and eliminate remainingtrade policy distortions,includingsubsidizedexportsofrice andwheat. Improve access to land by revisiting current legislation on land tenancy, and building on successful initiatives to improve land administration. Devise market-based solutions to improve rural access to a largerrange of financial services, at lower cost. xix PARTI:ASSESSMENT OFDEVELOPMENTOUTCOMES Overview 1.1 India has continued to make progress in increasing incomes and improving living standards over the past decade. After the setback associated with the 1991 balance-of-payments crisis, economic growth picked up, income poverty has continued to decline, and many social indicators have continued to improve. These developments were supported by wide-ranging reforms launched in 1991 to open and deregulate the economy. Reforms included abolition o f all quantitative restrictions on non-consumer goods, reduction in tariffs, unification o f the exchange rates, adoption o f more liberal rules for Foreign Direct Investment (FDI), and introduction of current account convertibility. Even though the pace o f reform has slowed since the mid 1990s, cumulative changes so far have been substantial. More sectors have been opened to private activity, trade policy and the exchange-rate regime have been further liberalized, and capital markets have been reformed, leadingto an improved investment climate. 1.2 Development progress has been steady, but uneven. It has been uneven across indicators o f living standards, with noteworthy progress insome areas, but little or no progress in others. Poverty and improving education indicators improved, particularly for females. On the other hand, maternal and under-five mortality have hardly improved. The ratio o f females to males for children under four has deteriorated, especially inricher states. And unemployment, although still low by international standards, has increased in rural areas and among educated youth. Progress has been uneven in urban and rural areas, with urban-rural inequality increasing in most individual states and also at the all-India level. Progress has been uneven also regionally. There i s evidence o f divergence in per capita incomes across states, with richer states increasing incomes faster than poorer ones. Because in India increases in per capita growth are strongly correlated with declines inpoverty incidence, and because population growth has declined faster inricher states, poverty has become increasingly concentrated inthe country's slower growing states. Aggregate outcomes at the all-India level thus mask sharp and increasing inequalities in income and social development levels across the country, with large parts o f the heavily populated north and eastern states remaining particularly poor and undeveloped. There are large disparities not only between poorer and richer states, but also between rural and urban areas, between women and men, and between castes. 1.3 Recent trends also give reason for concern. Economic growth has slowed since 1997/98. from an annual average o f 6.7% between 1992/93 and 1996/97 (EighthPlan period) , to 5.5% between Figure1.1: PerCapita Income Trends 1997/98 and 2001/02 (Ninth Plan period). India and Comparator Countries Growth slowed further in 2002/03, to an I 1200 , estimated 4.4%, due to the impact of poor rains I on agricultural output. And fiscal performance deteriorated at the center and in states, with rising deficits and worsening public expenditure 400 composition limiting the prospect for accelerating growth andpoverty reduction. 0 4 I 1970 I g 8 O Years 1990 2000 1.4 With one third o f the world's poor and 1 +-India +China -+-Indonesia 1 over one billion people, India needs rapid growth Source: World Development Indicators, 2002 and job creation to reduce poverty and sustain income increases for its growing population.' It starts the twenty-first century with per capita income around half that o f China and Indonesia, countries that in 1970 were at comparable stages of development (Figure 1.1). In its Tenth Five Year Plan for 'Poverty estimatedusingintemationallycomparablepovertyestimate for the mid 199Os, based on an internationalpovertylineof US$lper daywith adjustmentsfor purchasingpower acrosscountries (Datt andRavallion,2002). 1 2002103-2006/07, the Government o f India (GoI) targets an average growth rate of 8% per annum. Accelerating poverty reduction does require setting India on a higher growth path. This chapter reviews the development outcomes o f recent years. The remainder of the report proposes policies to accelerate development inIndia. Poverty Outcomes and Economic Performance 1.5 Income poverty declined in the 1990s, broadly in line with earlier trends (Figure 1.2).2 Figure 1.2: Poverty and Per Capita Income Trends, As a result, the share o f the population living 1983-1999/2000 below the poverty line declined from nearly half 50 i T 20 in the early 1980s, to a little over a quarter in 1999/00 (26% according to Go1 official estimates or 28.6% according to alternative estimate^).^ Internationally comparable poverty estimates also show a decline in the proportion o f people living o n less than US$l/day, from 46% in the early 1990s to 39% in 1999100. 1983 19871aa 1993194 1999/00 These findings are consistent with other data -Poverty - incidence-GO1estimates (ieR axis) sources that show increases in real agricultural .Pover&incidence-adjustedestimates(iekaxis) ~ -Pera- capita income (right axis) wages over the 1990s, highly correlated with poverty incidence, and in consumption Source: PlanningCommission;CentralStatistical Organization;Angus Deaton expenditures in the National Sample Survey's (2002, adjusted povertyestimates) (NSS) 1999/00 employment unemployment survey (EUS). Box 1.1: Who are India's Poor? Poverty i s pervasive in India. It i s present in the country's rapidly growing cities and vast rural areas. But it i s increasingly concentrated in the country's lagging states and rural areas. Over half o f India's poor now live in one of four states: Bihar, Madhya Pradesh, Orissa, and Uttar Pradesh. Over two thirds live in rural areas. In rural areas, poverty incidence i s highest amongst agricultural workers, many of whom are small-scale farmers or casual laborers. People o f scheduled castes and scheduled tribes are far more likely to be poor than those o f other social groups, as low-caste status and gender barriers still operate as social obstacles that block or exclude them from opportunity. India's poor suffer not only from lower incomes, but also from lower access to and quality o f public services, such as basic health, education, and infrastructure. The poor often lack the leverage to ensure that state institutions serve them fairly and thus lack access to public facilities or receive goods and services o f inferior quality. They must often pay for education and health services that others receive for free. For example, studies by India's Public Affairs Center (Shekhar and Balakrishnan 1999) indicate that the wealthy and middle classes are more likely to resolve their complaints at a lower cost. Corruption is often a highly regressive tax and the poor pay more o f their incomes proportionately than do the wealthy and the middle class (World Bank 2002a). The conventional definition o f poverty equates it with income or expenditure levels. In India, GoI's Planning Commission defines poverty as the level of per capita consumer expenditure sufficient to provide an average daily intake o f 2400 calories per person in rural areas and 2100 calories per person in urban areas, plus a small allocation for basic non-food items. This report relies on income poverty estimates from the National Sample Survey's quinquennial rounds ("thick samples" o f 1983, 1987188, 1993194, and 1999100). Changes in the questionnaire design of the 55th Round (199912000) o f the National Sample Survey render the official poverty estimates for that year not strictly comparable to those from previous rounds. Several researchers attempted to correct for the changes inthe survey methodology. Most estimates (Sundaram and Tendulkar 2002, Deaton 2002, and Ravallion and Datt 2002) point to a 5 to 10 percentage point reduction between 1993194 and 1999100. Based on the national accounts, Bhalla (2002) contends that conventional poverty measures overstate India's poverty and understate recent progress. However, there are conceptual and measurement differences that lead to discrepancies in the per capita income growth rates implied by CSO's national accounts statistics and NSSO's household level statistics. 2 1.6 Most o f the reduction in income poverty has been driven by economic growth, a result o f increases in average consumption per capita (Deaton and Drbze 2002). Although India's per capita growth rates never reachedEast Asian levels, the acceleration o f growth inthe 1980sand 1990stranslated into a near doubling inper capita income over the last two decades, and a one third increase inthe 1990s alone (Figure 1.2).4 Aggregate growth has reduced poverty, but the pattern o f growth was also decisive (Ravallion and Datt 1995). Rural consumption growth reduced poverty in both rural and urban areas. Urban growth benefited the urban poor somewhat, but had no impact on rural poverty. Economic growth has also been a key determinant for the improvement insome social indicators inparticular inpoor states, where the private sector provides education and health services to a large share o f the population. 1.7 Macroeconomic performance. Overall, India's economy performed well in the 1980s and in particular after the reforms of the 1990s (Table 1.1). Inflation remained low and external balances improved. GDP growthaccelerated, fi-om only 3.5% per annum inthe 1960s and 1970s, to nearly 7% per annum between 1992/93 and 1996/97.' Growth was led by industry and services in the 1980s and by services in the 1990s (Table 1.2). Agriculture, forestry and fishing expanded slowly throughout the two decades. The structure o f the Indian economy changed considerably as a result o f these trends, with the share of agriculture declining to one fourth o f total output and the share of services increasing to nearly half. Table 1.IMacroeconomicTrends Over the Past Two Decades : 1980s 1990s 1992193-1996197 1997/98-2001102 2002103 GDP growth (% pa) 5.6 5.8 6.7 5.5 4.4 Agriculture, Forestry and Fisheries 3.4 3.0 4.7 1.8 -3.1 Industry 7.0 5.8 7.6 4.5 6.1 Services 6.9 7.6 7.5 8.1 7.1 Investmentrate (% of GDP) 22.0 23.0 23.3 22.5 22.1 Private 10.0 7.8 8.0 6.6 6.3 Public 12.1 15.2 15.3 15.9 15.7 Inflation (WPI, % per annum) 8.0 8.1 8.7 4.9 2.5 General government deficit (YOof GDP) 8.1 7.8 7.2 9.3 10.4 Current account balance (% of GDP) -2.1 -1.4 -1.2 -0.7 1.o External reserves (months of goods and services imports, end 3.3 5.6 5.9 7.0 11.0 of period) Notes: *Eighth Plan period "Ninth Plan period Source: Central StatisticalOrganization 1.8 Recent trends give rise for concern. First, fiscal aggregates o f the general government (center plus states) deteriorated since 1997/98, with the overall budget deficit expanding from 7% to over 10%o f GDPbetween 1997/98 and 2002/03. This deterioration has been due to a decline inrevenue mobilization, and a significant increase in government consumption, driven by higher wages and pensions o f civil Econometric analysis (Ravallion and Datt 1996 and 2002) using 23 surveys over the 1958-1991 period and private consumption per capita data from the national accounts reveal an elasticity o f -1.2, obtained by regressing the log o f the headcount poverty index against the log of private consumption per capita. A recent study by the Reserve Bank of India (RBI 2002c) identifiedtwo regime shifts in India's GDP growth series over the past two decades, which caused increases o f the trend growth rate o f GDP. The first occurred in 1981182, in the wake of an oil shock and a severe drought. The second break occurred in 1990/91 as a result o f the structural reforms and stabilization that followed the balance of payments crisis. 3 servants, food subsidies, and debt service. The effects o f nuclear tests, tight monetary policy to keep inflation low, and higher interest rates worldwide, contributed to higher interest costs. As a result, resources available for public investment became increasingly constrained, with Table 1.2: Sectoral shares of GDP, 1980/81 and 2001102 adverse consequences for infrastructure develoDment and to a lesser extent for Sectoral share of GDP f.c. (%). , 1980181 2001102 social programs. Interest rates have Agriculture, forestry and fishing 38 25 declined since, primarily because of low Industry 26 26 investment demand in India and the Services 36 49 current low interest rate regime worldwide 100 100 For government and prime borrowers. Source: Central StatisticalOrganization However, the public debt burden remains high and small and medium-scale enterprises continue to face high interest costs. With the exception o f the post 1990 crisis, when fiscal policy clearly encouraged macroeconomic stability and growth, it can be argued that fiscal policy has contributedto keeping growth below potential. 1.9 Second, economic growth decelerated, to 5.5% on average between 1997198 and 2001102, and to 4.4% in 2002103 (Table 1.1). Output from agriculture, which had performed poorly throughout the 1990s, actually contracted by 3.1% in2002103. Industrial growth slowedmarkedly between 1997198and 2001/02, and expanded at average rates below those o f the 1980s. The only exception i s the services sector, which continued to expandrapidly. 1.10 Sectoral Output Performance. Agricultural output expanded slowly in the 1980s and 1990s. Growth slowed further since 1997 partly as a result o f exogenous factors (extensive droughts in many states due to poor monsoons and flooding in some northern states). Two main factors contributed to the growth slowdown. First, the impetus from the green revolution that induced productivity increases in Punjab, Haryana, Andhra Pradesh and western Uttar Pradesh, dwindled. Second, public investment in agricultural infrastructure was limited. The minimumsupport price for foodgrains has given farmers little incentive to diversify and filled government storage facilities with grain stocks, while keeping the market price for foodgrains artificially high. Slow agricultural growth i s o f concern less because o f its contribution to India's overall output or food security concerns, and more because o f the sector's importance inthe country's economic, social and political fabric. The sector still provides employmentto a large share o f India's population, and an even larger share o f the poor. 1.11 Industrial growth slowed sharply after the mid-1990s. Following liberalization in the early 1990s, output and investment inthe sector expandedrapidly. However, because demand failed to expand as rapidly as expected, and facing greater competition from imports, the sector was left with excess capacity. Simultaneously, the domestic policy environment was not supportive of productivity increases. Severe infrastructure bottlenecks, such as expensive and unreliable power supply, poor roads, and several remaining distortions in product and factor markets, combined with lower external demand and rising interest rates, led to a slow down in industrial growth and investment from 1997/98 onwards. The sector has only recently begun to show signs o f recovery, namely with the index o f industrial production suggesting a recovery, particularly inthe capital goods subsector. 1.12 Growth o f the services sector has been strong and broad based. One o f the reasons for the rapid growth o f services in the 1990s i s the rapid expansion o f India's information technology (IT) sector, which has turned India into one o f the world's leadingproviders o f software (Box 1.2). But other services A recent study by the Reserve Bank of India (RBI 2002c) identified two regime shifts in India's GDP growth series over the past two decades, which caused increases of the trend growth rate of GDP. The first occurred in 1981/82,in the wake of an oil shock and a severe drought. The second break occurred in 1990191 as a result of the structural reforms and stabilization that followed the balanceof payments crisis. 4 have also expanded, namely transport, trade, and financial services. The national accounts reflect an increase in the value added o f public administration. However, if GDP estimates were corrected for the "spurious" addition to growth caused by the use o f the wage bill to estimate value added o f government services, aggregate GDP growth between 1997/98 and 1999100 would have been lower by about half a percentage point annually (Acharya 2002a). Box 1.2. India's Success inInformation Technology (IT) India has emerged as a leader among developing countries in providing cross-border IT services. Although the IT industry in India has more than three decades o f history, its take-off into a major software business i s a recent phenomenon, with the southem city o f Bangalore, and more recently Hyderabad, Chennai, Mumbai and Pune emerging as competitive IT hubs. Some critics assert that India's "new economy" has little to offer to the majority o f Indians who are not engineers, and that India's IT sector i s essentially an export enclave. Others point out that India cannot live o f IT services alone. Although there is some truth to these assertions, India's new economy, beyond making an increasing contribution to GDP and exports, also sets an example for the old. It has grown from US$ 1 billion (or 0.3% o f GDP) in 1990/91, to US$9.6 billion (or 2% o f GDP) in 2001 and the share o f IT (mainly software) in total exports, has jumped from 1% in the early 199Os, to 18% in 2001. Several factors contributed to this take-off: the existence o f a skilled, Englishspeaking workforce corning out o f India's engineering schools and eaming lower wages than European and US counterparts, low dependence o f IT on physical infrastructure, and introduction o f current account convertibility and easing o f controls and regulations inthe early 1990s. IT-enabled services such as back-office operations, remote maintenance, accounting, public call centers, medical transcription, insurance claims, database, and other bulk standards processing, are also expanding rapidly inIndia. While at an earlier stage of development, IT-enabled services (which require an Englishspeaking workforce and reliable telecommunications infrastructure) have the potential for broader job creation than IT itself. 1.13 Investment, which in the past had enabled phases o f acceleration and stability in periods o f slowdown (RBI, 2001), declined markedly since 1997/98, raising concerns about future growth trends.' Public investment was clearly crowded out by expanding public consumption and debt service. Several economists (Sundarajan and Thakur 1980 and RBI 2001) agree that the slowing down o f public investment in the 1990s contributed to the slowing o f private investment, as there appears to be a crowding-in phenomenon between certain types o f public and private investments. Private investment slowed for several reasons. Following the high growth rates o f the early 1990s, firms invested and borrowed heavily in the mid 199Os, building capacity for a continued expansion in domestic demand. Businesses invested based on the expectation that the pace o f regulatory and infrastructure reform and investment would remain rapid and thus contribute to higher productivity o f investment. In the meantime, trade reform left some sectors more open to competition, while they still faced behind the border constraints to improved productivity. As the pace o f reform slowed, interest rates rose, and the expected demand fi-om high overall growth rates failed to materialize, many firms found themselves saddled with excess capacity and debt. 1.14 External sector. India's integration into the global economy increased during the 1990s. The real depreciation of the rupee after the 1990/91 crisis promoted exports and the reduction o f import barriers allowed more foreign goods into the country. Exports o f goods and non-factor services rose from 7.5% o f GDP in 1990/91to 10.5%in2001/02. 1.15 The balance of payments has strengthened considerably in recent years. The performance of merchandise exports has been somewhat erratic as the stimulus fi-om the steep real depreciation o f the rupee in the early-1990s has faded, and been replaced by upward pressure on the currency. Sluggish domestic demand growth, however, has more than offset the impact o f gradual relaxation o f import barriers, and import growth has been modest in recent years. The trade deficit, therefore, has roughly halved since 1990/00 from around US$12 billion to around US$6 billion this year. Exports o f IT services have increased sharply, and remittances have edged up. The current balance, which swung into a deficit o f 3.4% o f GDP in 1990/91and a further deficit o f 1.7% in 1995/96,has shifted into small surplus. 'Giventhe low degree of openness of India's economy, extemal demand has played a small role in influencing the course o f businesscycles. 5 1.16 Capital inflows picked up strongly in response to the reforms o f the early-1990s but have subsequently been more modest. Foreign direct investment and equity inflows have eased from their peaks, and borrowing from both official and private creditors has typically been more moderate. The level o f external debt has risen modestly and has fallen from almost 40% o f GDP in the early-1990s to around 23%. The combination o f an improving current balance and even modest capital inflows, however, has been enough to allow a substantial building o f reserves, which have risen from US$17 billion in 1995/96 to around to more than US$80 billion currently - equivalent to almost 12 months o f imports. 1.17 The external sector, however, continues to play a relatively modest role and India remains considerably more closed than other large Asian economies, where exports account for much larger shares o f GDP - 29% in China, 34% in Indonesia and 41% in South Korea. India's share o f world merchandise exports edged up from 0.5% in 1990 to 0.7% in 2001, but remains relatively modest for the size o f the economy. GoI's cautious approach to opening the economy further inrecent years reflects a desire to avoid a repetition o f the balance o f payments crisis o f the early-l990s, especially as fiscal imbalances re-emerge and domestic vested interests, concerned about their ability to compete against foreign companies, increase their resistance to further trade liberalization. 1.18 Unemployment rates in India are not high by international standards Table 1.3: Unemployment Rates, India and Comparator Countries (Table 1.3), but recent trends have raised concern, as reflected in GoI's Countries Year Unemployment Rate (%) Tenth Plan. Unemployment rates based India 1999100 4.4 on National Sample Survey (NSS) data China 1996 3.0 have been traditionally low in India, Indonesia 1998 5.5 regardless o f which o f the four Brazil 1998 9.0 unemployment measures CLTpSS, UPS, Pakistan 2000 5.9 CDW, and CDS) is used.* All four Source: World EmploymentReport2001 (ILO) measures, however, show an increase in unemployment between 1993/94 and 1999/00, explained almost entirely by Figure 1.3: Unemployment Rates an increase in unemployment in rural - (Current Weekly Status), 1987188.1 999100 areas (Figure 1.3 and Statistical Annex io- 2 8 1 I Table A21). An analysis o f 7-\ J 6 - disaggregated unemployment figures in the rural sector suggests that this deceleration in rural employment -00 23 - -5 growth i s due to a decline in 1 1, employment in agriculture, due to slow EE20 4 =I agricultural growth, combined with low 1987188 1993194 I999100 capacity o f rural industry and services Year 1 -India +Urban -A- Rural 1 to absorb the labor released from Source: Task Force on Employment Opportunities, Planning Commission 2002 agriculture. The share o f employment inthe organized sector remains low, and unemployment rates are highamong certainpopulation groups, such as urban educated youth, and incertain states, such as Kerala, Tamil Nadu, and West Bengal. The NSSO provides four different measures o f unemployment, which capture different facets of the labor market situation: Usual Principal Status (UPS), UsualPrincipal and SubsidiaryStatus (UPSS), Current Weekly Status (CWS), and Current Daily Status(CDS). 6 Social Outcomes 1.19 Social progress in India has been uneven. Education indicators have improved markedly, but progress in health has been mixed (Table 1.4). For the first time since independence, the absolute number of illiterates in India declined between 1991 and 2001. Literacy rates rose, in particular for women. Enrollment rates o f primary-aged children rose and the gap between the enrollment ratios o f boys and girls declined. Table 1.4: Progress on Social Indicators, 1980-2000 1980s 1990s 2000 Poverty Poverty incidence (%) 44.5 36.0 26.1 Adjusted poverty incidence (%) na na 28.6 Demographics Population (million) 685 a46 1027 Rate of population increase (%) 2.4 2.2 na Overall sex ratio, 0-4 age group (females per 1000 males) 978 955 927 Education Overall literacy rate: 7+ years (%) 44 52 65 Female literacy rate as a percent of male literacy rate (%) 53 61 71 Net enrollment rate (NER): lower primary (%) na 71 77 Net enrollment rate (NER): upper primary (%) na 70 74 Female NER as % of male NER: lower primary (%) na a4 90 Female NER as % of male NER: upper primary (%) na 78 86 Dropout rate in grades 1-5 (%) 54 45 40 Health Life expectancy at birth (years) 56 60 61 Infant mortality rate 0-4 years (per 1000 live births) 115 79 68 Under-five mortality rate (per 1000 live births) 152 94 95 Maternal mortality rate (per 100,000) na 424 540 Malnourished children below age 3 (%) na 53 47 Prevalence of HIV (million people) na 3.5 4.0 Sanitation Access to improved water resources (%) na 68 78 Number of households with toilet facility (%) na 30 36 Notes: Poverly estimatesare for 1983,1993194and 1999100.Demographicsand literacy rates are for 1981,1991 and 2001. Enrollment rates are for 1981, 1991and 2000. Dropout rates are for 1982, 1993and 1999.Healthand sanitation data for 1992/93 and 1998199.HIV prevalence is for 1998 and 2001. Improvedwater resourcesdefined as access to pipeddrinking water and handpumps Sources: Poverty- PlanningCommission (based on NSS),adjusted poverty estimates- Deaton (2002); Demographics- Census; Education- NSS, Census, Dept.of Education,Gol; Health - Census, NFHS, Sample registrationSystem; HIV-NACO;Sanitation-Census,NFHS 1.20 Health indicators improved slowly or, in some cases, not at all in the 1990s. Between 1992/93 and 1998/99, the infant mortality rate fell from 79 to 68 per 1,000 live births and population growth slowed. However, progress has been absent in reducing India's high maternal mortality and under five mortality rates, and limitedin addressing malnutrition. Many of these outcomes have to do not only with healthpolicy, but also with slow progress inimproving access to safe water and sanitation. 7 1.21 Other trends raise concern. An estimated four million people in India are now infected by the HIV/AIDS and the rate o f infection i s increasing. The overall sex ratio for children under four continued to deteriorate inthe 1990s.' And although polio has disappeared from most countries, India i s one o f the seven where polio is endemic, and in 2002 accounted for 85% o f all confirmed polio cases in the world (World Heath Organization2002). 1.22 These trends are worrisome and also somewhat surprising. Worrisome, because they suggest that increased public expenditures alone will be insufficient to improve outcomes. Public expenditures on health and education have increased over the 1990s. Surprising because the 1990s witnessed a large increase in compensation to civil servants, including education and health professionals, which could have contributed to improvements in the delivery o f basic education and health services. There i s no evidence that it did. On the contrary, households (in particular poor households) are increasingly resortingto the private sector to provide education andhealth services. Economic and Social Outcomes: A Regional Perspective 1.23 India's good aggregate performance masks increasing divergence inper capita incomes, poverty, and other indicators o f well being between richer and poorer states. There i s no evidence o f convergence in per capita incomes across states, as suggested by a number of time-series studies covering different time periods, including a 2002 analysis o f 1980-98 growth data for India's 14 most populous states (Sachs, Bajpai and Ramiah 2002).'" " 1.24 Although poverty declined inpoorer and richer states, the extent o f progress inpoverty reduction varied. In richer states the rate o f poverty reduction has been greater, while in the poorer states poverty reduction has been more limited. An important part o f the explanation i s that regional economic growth has been unbalanced, slower in the states that were poorer to start with. As noted by Deaton and Drkze (2002), the states with the poorest initial conditions grew more slowly than the rest, resulting in an increase in regional Table 1.5: Concentration of Poverty in India inequality.12 Faster population growth in those states With % of total number of poor 1983 1987188 1993/94 1999100 initially higher incidence o f Poorerstates* 70 70 71 76 poverty has led a to Richerstates** 27 28 26 22 concentration o f poverty in Others 3 2 3 3 India's northem and eastern states 1'5)' In 999/00, 100 100 100 100 76% o f India's poor lived in Notes: includesAP, Assam, Bihar, Kerala, MP, Orissa, Rajasthan, UP, and W. Bengal includesGujarat, Havana, Kamataka, Maharashtra,Punjab,and Tamil Nadu poorer states, or states with per Source: Staff calculations,based on Planning Commission capita incomes lower than the all India average. Indeed, 54% o f the poor now live in four states alone: Uttar Pradesh, Bihar, Orissa, and Madhya Pradesh. Malung progress in poverty reduction in India requires, therefore, accelerating growth inIndia's lagging states. 1.25 As will be discussed in Part I1o f this report, these are also states with weaker state institutions, and where government finances are most severely stressed. Recent research by the World Bank and the Confederation o f Indian Industry suggests that a weaker investment climate in these lagging states may also be behindthis slower growth, as will be discussed inmore detail inPart 111. The differencei s due to female infanticide,the neglect of female children, and lately, the abortion o f female fetuses. loSee, for instance, Nair (1985), Chaudhury (1966), Majumdar and Kapoor (1980), Rao, Shand, and Kalirajan (1999), and Aiyx (2001). This is similar to the findings for China's provinces. Recent trends suggest that relative economic performance o f India's poorest states is improving, partly because they are growing faster and partly because growth in previouslyfast growing states is slowing. These trends should be interpretedwith cautionbecause: (a) recent GSDP estimates are subject to considerablerevisions; and (b) establishing convergenceor divergence rigorouslyrequires atime series longerthanjust 4-5years. 8 1.26 These diverging trends in growth and poverty reduction have translated into large disparities o f incomes and other indicators o f living standards (Figure 1.4). Average per capita incomes in 1997-2000 varied from over 15,000 rupees in Maharastra, Punjab, Haryana and Gujarat, to below 7,500 rupees in Orissa and Uttar Pradesh, and below 5,000 rupees inBihar. While the relative position o f a state i s rarely identical across different indicators, broadly spealung, disparities inper capita income betweenricher and poorer states are mirrored in other development indicators, e.g., o f poverty, health, education, safe water, and sanitation. The average person born inthe state o f Maharastra inthe mid-1990s was expected to live 65 years, whereas a person born the same year in the states o f Bihar, Orissa, or Assam would not be expected to live past 57. The exception i s the sex ratio, the number o f females per thousand males, which i s worse and deteriorating faster in richer states, such as Haryana, Maharastra, Delhi and Punjab, than in poorer ones. Figure 1.4: State-Wise Per Capita Income 3 year average (1998/99 to 2000101) ChandJelni arn Maharasntra Haryana PunjaD Tam Naad GL arar Karnataka h macnal IhDlA Andhra Praaesn Kera a Megnalaya Arunachal WestMan Rajasinan Bengal Tr p,ra pur Maanya Praaesn Unar Praaesn Assam Orissa Binar 0 5000 10000 15000 20000 25000 30000 35000 Rupees 199798to 199900 Rj 11,124 Source: Central Statistical Organization AcceleratingDevelopmentinIndia: Goals andPolicyAgenda 1.27 Increasing growth to 8% and accelerating progress in a wide range o f living standards indicators are the goals set out in Government o f India's Tenth Plan (Box 1.3). However, there are macroeconomic vulnerabilities and structural impediments that limit India's ability to accelerate development, as the Plan and the most recent Economic Survey recognize. Meeting these goals will require a radical departure from current policies. Some o f these structural weaknesses may already help explain the growth slowdown o f the past five years, suggesting that the highgrowth rates o f the mid-1990s were an outlier, rather than a shift to a higher growth trend. They also help explain the mixed performance in improving living standards andthe persistence o fregional disparities. 9 Box 1.3: Targetsfor the TenthPlanand Beyond Macroeconomic Increase annual economic growth to 8% during the TenthPlanandto 9.3% during the EleventhPlan Doubleper capita consumption level in 13 years: private consumption expenditure to grow at 6.9% per annum andper capita consumption growth at 5.3% per annum inthe Tenth Plan Achieve 12.4% per annumgrowth in exports Restore agricultural growth to 4% per annum; increase industrial growth to 8.7%, services growth to 9.3% per annum over the TenthPlanperiod Reduce the Gross Fiscal Deficit o f the center and states from 10.4% of GDP in2001102 to 6.5% o f GDP in2006107 Increase investment rate to 28% and savings rate to 27% of GDP, Poverty Reducethe poverty ratio by 5 percentage points to 21% by 2007 and by 15 percentage points to 11% by 2012 Demographics Reducethe population growth rate from 21.3% between 1991and 2001 to 16.2% between 2001 and 2011 Employment Provide gainful, high-quality employment to at least the addition to the labor force Reduce the unemployment rate to 5.3% by 2006-07 Education Ensureall children inschool by 2003; all childrento complete 5 years of schooling by 2007 Reduce gender gaps inliteracy and wage rates by at least 50% by 2007 Increase literacy rate to 75% within the Planperiod Health Reduce InfantMortality Rate from 70 to 45 per 1000 live births by 2007 andto 28 by 2012 Reduce Matemal Mortality Rate to 2 per 1000 live birthsby 2007 and 1 per 1000 live birthsby 2012 Reducethe average prevalence o f underweight children under three from 47% to 40% by 2007 Reduce severe under-nutrition inchildren inthe 0-6 year age group by half Achieve zero-level growth of HIV1AIDSinfection by 2007 Increase utilization o fpublic health facilities from 20% at present to 75% by 2010 Sanitation Provide all villages sustained access to potable drinkingwater within the Planperiod Clean major polluted rivers by 2007 and other notified stretches by 2012 Environment Increase forest and tree cover to 25% by 2007 and 33% by 2012 Source: Go1Tenth Five year Plan for 2002103 to 2006107 1.28 The next two parts o f this report look at the policy agenda to raise growth and achieve the goals of the TenthPlan. These reforms can be grouped into two broad areas: (a) improving the management o f public resources, by reducing budget deficits, reallocating spending to more productive expenditures, and enhancing the quality o f service delivery; and (b) improving the investment climate and raising productivity inindustry, services, apculture and rural development. The final part of this report looks at the potential impact o f these reforms on growth and poverty reduction, and the main risks that may jeopardize realization o f these results. 10 PART 11:POLICY AGENDA MANAGINGPUBLIC RESOURCES - 2.1 The public sector has always played a major role in India's development strategy. Reforms during the 1990s reduced the role o f the state and improved the environment for private investment. However, developments in the public sector continue to have a major impact on the prospects for economic growth and poverty reduction. Inthis context, the recent deterioration in the fiscal position at the center and in the states i s a cause for concem. The center and states combined are now spending almost all o f their revenues on interest payments, subsidies, civil service salaries and pensions, administration and defense. O f particular concern are power sector losses that are placing massive stress on virtually all state budgets. As a result, there are limitedresources for public investment, at the same time as large deficits are threatening to crowd out private investment. And even when funds are available, the delivery o f services to the poor i s constrained by weaknesses in public institutions and the regulatory fi-amework for private sector contributions. 2.2 Part 11.1reviews the current debate around fiscal sustainability, and proposes a number o f reforms in fiscal policy and public resource management to steadily reduce the primary deficits at the center and state levels, and improve the composition o f public expenditure. Part 11.2 considers longer-term reforms inthe civil service to improve the delivery ofpublic services. Itthenlooks more closely at the situation inthe health and education sectors, as well as for social safety nets, and suggests possible reforms to improve the prospects o f achieving the targets set by the Tenth Plan and the Millennium Development Goals. II.1:FISCAL POLICY Introduction 2.3 India's balance-of-payments (BOP) crisis in 1991 followed an acceleration ingrowth to 5.6% per annum during the 1980s from a , trend annual rate o f 3.5% per Figure2.1: GeneralGod.Deficitand DebtStock (1985186-2002103) annum over the previous three (% GDP) decades. But large fiscal deficits fed into current account 120 FiscaldeficitlGDP(Oh) DsbtotofklGDP(Oh) 90.0 deficits and depleted foreign 11.0 exchange reserves, pushing 80.0 India to the brink o f default in 10.0 1991. Figure 2.1 shows that 9.0 70.0 the general government fiscal 8 0 60.0 deficit (center and states consolidated) averaged 9% o f 7.0 50.0 GDP before the crisis. 6.0 Subsequently, it fell sharply 5.0 40.0 during the period o f high growth and fiscal restraint that 4.0 ~ 30.0 6.5'86 87\88 89190 91/92 93194 95/96 97198 99103 01/02 marked the Eighth Plan period, ---c)--Rscd DeficitlGDP * DebtSdxklGDP but resumed gowing equally Source : Budget bcumnts, RBI, Ministryof Finance,IMFand Staff Estimates 2.4 Figure 2.1 also shows that the general government Table 2.1: General Government FiscalTrends debt-to-GDP ratio rose from (% of GDP) approximately 58% in 1985186 to 85% o f GDP in 2002103, at 85186-89190 8th Plan 9th Plan 02/03 which time public sector debt Avg. Avg. Avg. Est." (general government plus central Revenues 19.4 17.9 17.0 18.4 public enterprises) stood at 95%. Currenf expenditurez 22.1 21.5 23.1 25.3 Contingent liabilities from Social services 5.4 5.0 5.6 5.7 guarantees in support o f loss- m a l n g public enterprises, Economicservices 6.5 5.8 5.5 6.5 largely in the power and General services 9.5 10.3 11.7 12.8 irrigation sectors, amounted to Capitalexpendifure3' 6.4 3.6 3.2 3.5 12% o f GDP. Gross fiscaldeficit 9.0 7.2 9.3 10.4 2.5 Inadditionto the bigrise Memo in the debt burden, the Primary deficit 5.3 2.1 3.5 3.8 deterioration inthe quality o f the Revenuedeficit 2.6 3.6 6.1 6.9 fiscal stance during the 1990s Interest 3.8 5.1 5.8 6.5 has been another serious (irrigation+power+transport)/GDP 4.7 3.5 3.5 3.8 concern. Table 2.1 shows (Interest+adinin.+pensions)/GDP 6.3 8.1 9.2 10.1 trends in revenues and (Interest+adinin.+pensions)/Revenue 32.6 45.1 54.3 54.8 expenditure for the general Notes: "Revised estimates for the center and budget estimates for the government, with data values states ZRefers to Revenueexpenditure in the budget over 1985186-1989190, the five YRefers to Capital outlay and net loans and advances from the center to the states years preceding the 1991 crisis, Sources: GO1budget documents(2003104and various issues), RBI bulletins, CSO, Handbook of Statistics on Indian Economy 2001102 (RBI), Staff estimates 12 as a benchmark. The 1990s are divided into the period o f rapid growth, 1992193-1996197, which coincided with the EighthPlan; and the slowdown, 1997198-2001102, which coincided with the Ninth Plan period. 2.6 Revenues fell considerably during the NinthPlan period relative to the second half o f the 1980s. While 2002103 shows a large revenue increase, it i s based on the budget estimate for states, which tends to be optimistic. Compared to the average for the second half o f the 1980s, capital expenditure fell by over three percentage points o f GDP duringthe NinthPlan, while the sum o f interest, administrationand pensions rose by three percentage points o f GDP and a massive 22 percentage points o f revenue. Revenue deficits more than doubled with spending on interest, administration and pensions crowding out that on social and physical infrastructure. Even the fiscal improvement secured during the EighthPlan period involved a large compression o f capital spending. l2 Table 2.2: Trends in Central Government Finances (% of GDP) 85186-89190 8th Plan 9th Plan 02/03 03/04 Avg, Avg. Avg. RE BE Revenues 10.4 9.2 8.9 9.7 9.3 Tax revenue(net) 7.8 6.8 6.2 6.7 6.8 Nontax revenue 2.5 2.5 2.7 3.0 2.6 Currentexpenditure 12.9 12.1 12.7 13.9 13.4 Interest payments 3.2 4.3 4.6 4.7 4.5 Subsidies 1.8 1.2 1.3 1.8 1.8 Salaries 0.0 1.1 1.o 1.3 1.2 Pensions 0.4 0.4 0.7 0.6 0.6 Defense 2.5 1.6 1.7 1.7 1.6 Capital expenditure 4.3 2.2 1.8 1.8 2.0 Capital outlay 2.6 1.4 1.I 1.2 1.5 Net lending 1.7 0.8 0.7 0.6 0.4 Gross fiscal deficit 2/ 6.9 5.1 5.6 6.1 6.1 Memo Primarydeficit 3.7 0.8 1.o 1.3 1.6 Revenuedeficit 2.5 2.8 3.8 4.3 4.1 Notes: BE=BudgetEstimates; RE=RevisedEstimates 1'Excludesstate'sshare of netsmall savings loans 21 Divestment receiptsaretreated as a financing item and notas revenuesin computing the deficit Sources: Budgetdocuments (2003-04;various issues),Staff estimates 2.7 Table 2.2 contains information on fiscal developments at the center. Revenues declined substantially during the Ninth Plan period relative to the pre-crisis benchmark, while interest payments, s~bsidies,'~civil service ~alaries'~and pensions, administration and defense literally consumed 100% o f revenues. The primary deficit more than halvedbased on the same comparison, while the revenue deficit increased substantially - which i s explicable by the displacement o f capital spending by rising interest payments. The fiscal deficit has been reduced, but the quality o f the fiscal stance has worsened. It was hoped the private sector would step into the breach and invest in infrastructure; but this has not happened on the desired scale except for telecommunications. As noted in RBI (2003a), 111-46, a bigger private role in infrastructure would require institutional reform and "economically efficient user charges to ensure the reasonable retum o n investment". l3Explicit budgetary subsidies. l4Excluding railways and posts and telecommunications. 13 According to the revised estimates (RE) for 2002/03, there has been an encouraging increase inrevenues compared to the NinthPlan average; but interest payments, the primary deficit, the revenue deficit and the gross fiscal deficit have all increased. 2.8 Table 2.3 captures trends inrevenues and expenditure at the consolidated state level. The story here mirrors that o f the center, except that the gross fiscal deficit rose significantly after falling during the EighthPlanperiod. Revenue deficits have grown alarmingly, while capital expenditure was cut inpart to accommodate growing interest payments. The share in central taxes plus grants almost fully explains the decline inrevenues duringthe NinthPlan period relative to the second half o f the 1980s. Once again, the signs o f a deterioration in the fiscal stance are unmistakable. Interest spending has risen, capital expenditure has declined and developmental spending stagnated, even though the states have primary responsibilityunder the Constitution for povertyreduction and welfare o f the population. Table 2.3: Trends in State Government Finances (%of GDP) 85186-89190 8th Plan 9th Plan 02103 Avg. Avg. Avg. PL Revenues 12.2 11.8 11.0 12.0 Share in central taxes 2.7 2.6 2.4 2.5 Grants from the center 2.2 2.1 1.7 2.2 Current expenditure 12.3 12.6 13.3 14.5 Education 2.6 2.5 2.7 2.7 Health and family welfare 0.8 0.7 0.7 0.7 Agriculture and allied services 1,I 0.9 0.8 0.7 Rural development 0.8 0.7 0.5 0.5 Interest payments 1.4 1.9 2.4 3.0 Administrative services 1.2 1.2 1.2 1.2 Pensions 0.4 0.7 1.o 0.9 Other 3.9 4.0 4.0 4.6 Capifal expenditure 2.7 1.9 1.9 2.2 Capital outlay 1.9 1.5 1.5 1.8 Loans and advances (net) 0.9 0.4 0.4 0.4 Gross fiscal deficit 2.8 2.6 4.2 4.7 Financedby: Internal debt (net) 0.5 0.5 0.7 0.6 Loans from center (net) 1.8 1.2 0.9 0.5 Provident and insurance funds (net) 0.4 0.5 0.6 0.5 Memo: Primary deficit 1.4 0.7 1.8 1.6 Revenue deficit 0.1 0.7 2.3 2.5 Source ;State Finances- RBI bulletin (variousissues), Staff estimates 2.9 While a mechanical comparison o f the numbers for the general government, center and state? shows that most o f the increase inthe general government's revenue deficit between the second half o f the 1980sand the NinthPlan period i s traceable to a big deterioration in state finances, the underlying causes l5 Note that the general govemment gross fiscal and primary deficits differ from the sum o f the respective deficits at the center and states because of the netting out o f interest paid by the states to the center and net lending from the center to the states (which i s a component o f capital expenditure). 14 are a complex mix o f fiscal developments at the center and states. For example, regarding devolution, transfers (tax shares, grants and loans) from the center to states declined from 7.4% o f GDP in 1985/86 to 5% in 2002/03. Similarly, the impact o f the Fifth Pay Commission, which has had a big impact at the level o f the states, i s one where the latter were following the example o f the center (Acharya 2001, 2002a). The states have also suffered from rising interest rates over the 1990s inpart because o f the high, administratively-determined interest rates on "small savings" loans (Rao 2000). GovernmentDebtDynamicsandExternalVulnerability 2.10 Inspite ofthe growing debt burden andrisingrevenue deficits, one view is that the large fiscal deficit i s not a serious problem because RBI's foreign exchange reserves are at record levels as are food stocks.16 This view asserts that the high fiscal deficit has served to countervail the slowdown in the private sector and that India will eventually grow out o f its debt problem. Developments over the past 18 months superficially appear to support this viewpoint: inflation and interest rates have reached their lowest levels ever; foreign exchange reserves have continued their remarkable growth; and according to banks, the demand for credit from industry remains low, while there i s considerable excess capacity in manufacturing. 2.1 1 Arguing in favor o f a fiscal consolidation is the worsening trend in debt dynamics discussed below in the context of Table 2.4 and Figure 2.2. It i s one thing to run a 10% deficit when general government debt i s less than 60% o f GDP, as it was in 1985/86, and quite another when it i s more than 25 percentage points o f GDP higher, as it i s today, with guarantees amounting to another 12% o f GDP. Moreover, the increase in the general government debt-to-GDP ratio has accelerated from less than 2 percentage points o f GDP per year over the first three years o f the NinthPlan period (1997/98 to 1999/00) to over 4.5 percentage points of GDP per year over the last three years (2000/01 to 2002/03) in spite of the low interest rates. While interest rates on government debt have fallen sharply at the margin, these will have to persist for several years to improve debt dynamics, which are drivenby the weighted average yield o f all outstanding debt minus the growth rate. 2.12 Therefore, the second issue on which ajudgment i s neededi s how long interest rates will stay low and whether this will be sufficient to stimulate growth without a fiscal adjustment and faster structural reforms. Interest rates been driven by a combination o f weakness in the world economy, which has pushedOECD interest rates to 50-year lows,l7 and capital inflows. To the extent that capital flows into India have been driven by one-off events since September 11, 2001 including fears o f increased scrutiny o f accounts held overseas as part o f anti-money laundering drives or by the instability in Iraq more recently, it would be risky to slow fiscal reform on a gamble that such flows will continue indefinitely.18 Onthe other hand, the increase inIT-relatedexports andremittances from abroad, which have contributed to unprecedented back-to-back current account surpluses over the past two fiscal years, might well continue, although the bulk o f the increase in RBI reserves i s still explained by the capital account. If capital flows subside and the global economy picks up, interest rates will once again be determined by medium-run inflationary expectations as molded by fiscal and macro fundamentals. These are now analyzed and strengthen the case for a fiscal adjustment. l6 a For statement of this view andarefutation, see RBI(2003a), page IV - 23. '*World l7 Bank(2003c), page4. Interestingly,acoincidentreservebuild-uphas beenobservedinall the SouthAsian countries. 15 Government Debt Dynamics 2.13 Table 2.4 provides data on fiscal deficits for the general government, as well as current account balances and reserves. Also included are data on net public debt, dehned as general government debt minus net domestic assets and net foreign assets o f RBI plus its non-monetary liabilities; and on RBI foreign exchange reserves. Net public debt compactly captures the joint position o f public debt dynamics and international1iq~idity.l~ Table 2.4 :Key Macroeconomic Aggregates Precrisis period 02/03 03/04 85/86 - 89/90 Crisis 8th Plan 9th Plan 90191 avg. avg. RE Proj. % GDP Gross fiscal deficiti/ 9.0 9.3 7.2 9.3 10.4 9.8 Revenue deficit 2.6 4.0 3.6 6.1 6.9 6.2 Primary deficiti/ 5.3 4.8 2.1 3.5 3.8 4.1 Debt outstandingz 70.6 72.5 65.1 79.8 85.0 Net public debt2/$31 60.1 63.8 53.8 70.2 76.3 Memo InteresVRevenue % 19.4 24.6 28.5 34.0 35.3 Forex reserves $ bn2/ 4.0 5.8 26.4 54.0 75.4 Current account balancelGDP % -2.2 -3.1 -1.2 -0.7 1.o Real GDP qrowth % 5.9 5.6 7.1 5.5 4.4 Notes ;BE= Budget Estimates, RE=Revised Estimates "For the generalgovernment,The figuresfor 2002103 are revisedestimates for central god. and budgetestimatesfor state governments. For 2003104, the figures are budget estimatesfor centerand staff estimatesfor states. ZFor end of last fiscal year in period. Externaldebt is at currentexchange rates. "See text for definition Source; Governmentbudget documents, Handbookof Statisticson Indian Economy2001-02, Staff estimates 2.14 Except for the primary fiscal deficit and current account balance, Table 2.4 depicts an across-the- board deterioration during the Ninth Plan relative to the second half o f the 1980s and an even more striking deterioration relative to the EighthPlan. General government debt fell fi-om 71% o f GDP at the end o f 1989/90 to 65% at the end o f the Eighth Plan period but then rose an alarming 15 percentage points by the end o f the Ninth Plan, and another five percentage points the following year, notwithstanding the record lows in interest rates. Net public debt displays a similar trajectory: the rapid accumulation o freserves i s being offset byrising government debt and sterilization. Analyses of publicdebt sustainabilityfor Turkey, for example, usethe notionofnet publicdebt. 16 2.15 Interest payments consumed less than 20% of total revenues inthe pre-crisis period compared to over 30% during the NinthPlan period, while revenue deficits doubled from less than 3% in the second half of the 1980s to 6% duringthe NinthPlan period and beyond, capturing a deterioration inthe quality o f the fiscal stance with spending on social and physical Figure 2.2 :Primaly Deficits andthe Implied Difference betweenthe Real Rate of Interest infrastructure crowded out by and Growth (r-g) rising interest and other current payments as shown in Table 2.1 '0.0 1 Percent above. At the same time, general 8.0 government debt dynamics have taken a sharp tum for the worse over the past four years, as shown 2.0 - in Figure 2.2, which graphs the primary deficit and implied difference between the real interest rate on the stock o f government debt and the real growth rate o f GDP.20,21 Primary deficits fell from pre-crisis levels -8.0 - duringthe EighthPlan period, but - - .10.0 J 2oFor details of the calculations underlyingFigure 2.2, see Pinto andZahir (2003). 21 A recent analysis of public debt dynamics is containedinLahiri and Kannan (2002). For related analyses, see Buiter and Patel (1992), Acharya (2001), Ahluwalia (2002a), Srinivasan (2001), Cashin et a1(2001). 22 See RBI(2003b) and Kapur and Patel (2003). 23 See Ahluwalia (2002a), Acharya (2001) and IMF (2002). 24 GO1(2002b) contains a cross-countrycomparisonof externaldebt indicators, which puts India ina favorable light. 17 boosting liquidity has been the shift towards long-term rupee debt in government financing after the 1991 crisis. The average maturity o f dated securities issued more than doubled from 6.6 years in 1997/98 to 14.3 in 2001/02.25 Moreover, about 90% o f central and state government securities are held by nationalizedbanks, State Bank o f India, RBI and L I C and the remaining are held by Unit Trust o f India, NABARD,employeesprovident funds andprivatebanks.26 2.18 Since the 1991 BOP crisis, interest rates have been liberalized, India has become more integrated into the world goods and capital markets and fiscal fundamentals have deteriorated relative even to the late 1980s. IMF (2002) notes that "total public sector debt relative to GDP in India i s much greater than inArgentina and Brazil, while the ratio for Turkey recently shot up (duringthe crisis) to around that of India." And further, primary fiscal deficits are larger - in fact, the other three countries have generally runprimary surpluses over the last decade.27 Cross-country comparisons are complicated by anumber of factors such as the currency composition o f debt, its maturity, whether or not the real exchange rate i s in equilibrium, whether privatization proceeds are included in revenues (thereby artificially boosting the primary surplus, as in Argentina);28 and the size o f contingent liabilities and potential balance sheet problems in the banlung and corporate sectors, a potent factor in the East Asian crisis o f 1997/98. Further, countries with unsustainable public debt dynamics which eventually experienced crisis, such as Russia and Argentina, simultaneously had low international liquidity. This combination proved intractable, even with substantial bailout packages; indeed, bailout packages could backfire in these circumstances, as they provide the means for private portfolio investors to exit and leave the country burdened with senior IF1loans denominated inhard currency. 2.19 India's public debt dynamics have worsened, with state government finances in a state o f crisis, significant NPAs in the financial system and a large volume of guarantees. But reserves are high and bolstered by limited capital account convertibility, a flexible exchange rate and the relatively long-term nature o f capital inflows, plus a pliant financial system which willingly holds long-term, rupee- denominated government paper. Hence, India i s not vulnerable to the type o f collapse suffered by Russia or Argentina. But it i s vulnerable to sub-standard growth without a fiscal adjustment. Costs ofthe Fiscal Stance 2.20 The growth target for the Tenth Plan i s 8% per year as part o f a strategy of doubling per capita GDP by the end o f the Eleventh Plan period. In order to achieve it, chapter two o f the plan document notes that the investment rate will need to rise by four percentage points to a little over to 28%, with domestic savings contributing an additional 3.5 percentage points and the rise in the current account deficit (CAD) the balance o f 0.5 percentage points. The ICOR i s assumed to fall from 4.5 to 3.6, investments to grow at 14%per annum compared to the long-run growth rate o f 6.5%, and consumption by 6.9% per annum. The chapter notes that private household savings rose over the Eighthand Ninth plans inresponse to the cut intax rates and consequent rise in disposable income. This could slow down inthe Tenthplanperiodbecause of theneedto raise the tax/GDP ratio, andhighlightsthe needto increase public savings from -1.7% in the base year o f the Tenth plan (2001/02) to +2.1% in its last year (2006/07). Unless this happens, the plan document i s quite specific that the growth target i s unlikely to be reached. It also cautions that the C A D should not be usedto slacken the public savings target, and that a safe upper limit i s 3% o f GDP. 25RBI (2002a). 26RBI(2001b), Table 111. 27IMF (2002), chapter 111,page 37. 28On this specific point and how it may have put a better complexion on debt dynamics, see Mussa(2002). 18 2.21 The plan document then compares the fiscal deficits projected under the above savings- investment scenario (the "desirable deficit" from a growth perspective) with the fiscal deficit that would achieve sustainability, defined as a stabilization Table 2.5: Sustainable and Desirable Deficits in the Tenth Plan Context o f the government debt/GDP ratio. The Sustainable Deficit" Desirable Deficit 21 BaseYear comparison i s summarized (1) (2) (3) Comparing in Table 2.5. g=6.5 g=a.o columns (1) and (3) Combined 7.4 8.6 6.8 9.3 indicates the sizable Center 4.4 5.2 3.6 4.9 fiscal correction needed States 3.0 3.4 3.2 4.5 at thelevel of the states Nofes:"Table 2.21 of Tenth Plan to achieve sustainability WTable2.22 of Tenth Plan even if growth o f 8% i s Source: Tenth FiveYear Plan, Go1 achieved. Comparing columns (2) and (3) shows that an even bigger fiscal correction i s needed to generate the needed public savings for investment and growth. Thus, achieving debt sustainability i s "easier" than generating the public savings consistent with 8% growth. In other words, growth could continue to be sub-standard even if a crisis does not erupt; avoidance o f crisis i s not enough. 2.22 India has a relatively closed capital account and substantial govemment ownership o f financial institutions. The incentives would favor govemment financing needs coming first with a residual claim for Figure 2.3 :Gross Capital Formation in Private Corporate Sector the private sector. Further, the higher and the General Government Deficit including Oil Pool (%GDP) the deficit, the higher the real interest rate and therefore the fewer the private sector investment projects likely to be GCF = 13.8.0.94 DEF R 2 = 0.41 profitable, increasing the severity o f 8.0 crowding out. Not surprisingly,there i s a well-documented negative association 9 9 m between fiscal deficits and private 6.0 investment, shown in Figure 2.3. 29 5.0 While one could argue that a rise in 8 e 4.0 fiscal deficits was needed to counteract I 3.0 the cyclical slowdown o f the private 7 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 10.5 sector, real interest rates for borrowers General GovernmentDeficit (incloil pool deficit) have remained high after 1996197 and Source: NationalAccounts Statistics,Budgetdocuments,Staffestimates through 2001102, averaging over 12% per annum as shown in Figure 2.4 based on Table 1 in Mohan (2003). There may be several reasons explaining the high real interest rates, including the interest rate liberalization o f 1993194, a sharp worsening in public debt dynamics and a pronounced shift towards long-term rupee debt in deficit financing, as discussed above. What has emerged in effect i s a mixture o f a "loose fiscal - tight money" policy3othat has helped to keep inflation low and prevented worsening public debt dynamics from spilling 29 See World Bank (2000) and Reynolds (2001). 30 The term "loose fiscal-tight money" refers to the additional burden on monetary policy to achieve stabilization goals and foreign exchange reserve targets given the deterioration in public finance fundamentals after 1996197, meaning higher real interest rates for the private sector. As RBI (2003a) paragraph 4.67 notes, "The growing reliance on market borrowing for financing the fiscal deficit has been accompanied by restraint on reserve money growth and moderation o f inflationary pressure. This has also had the effect o f raising interest payments". And paragraph 4.85: "Continuing foreign exchange inflows and the recessionary conditions enabled the Reserve Bank to move to a softer interest rate regime in spite o f a rising fiscal deficit." But the continuance ofinflows suggeststhat interest rates are still "too high" ina relative sense. 19 reserves, as happened in the late 1980s and Figure 2.4: Real Interest Rates (1990191-2001102) led to the 1991 crisis; but this has been at Percent 16.0 the expense o f growth and welfare, as rising ?. interest payments have crowded out I 1 spending 12,0 on social and physical infrastructure. Even though interest rates ,o,o have declined sharply over the past 18 8,0 months or so for a variety o f reasons inthe external environment, public debt dynamics have continued to worsen. 2.23 In addition, there are significant . micro barriers to financing the private sector, which could also act to prevent the -4,0 decline inmarginalinterest rates on Source: Speech by Rakesh Mohan, RBI Monhly Bulletin (Jan 2003) 20 Fiscal R e f o r m Priorities 2.26 InadditiontotheTenthPlandocument, concerns aboutthefiscalsituationhavebeenexpressedin key government reports and pronouncements. According to the Economic Survey, 2002-03, "Higher fiscal deficits, besides constraining growth have resulted in higher government borrowings.. .. The revenue deficit which constituted 49.4% o f the fiscal deficit in 1990/91 accounted for 70.2% o f fiscal deficit in 2001/02.. ..While the expenditure composition both for the center and states continues to reflect a preponderance o f wages, salaries, interest payments and subsidies, there has been some welcome relief on the interest rates in recent months. The high fiscal deficit continues to complicate the task o f conducting counter-cyclical fiscal policies and augmenting outlays on the much needed social and physical infrastructure, and poverty alleviation programs." During the 2003/04 Union Budget discussions, the Finance Minister informed the Rajya Sabha on March 14, 2003 that "Of our revenue, 25% on defense. What am Ileft with?"31 And RBI(2003a) page IV - 1, notes that "...fiscal performance 50% i s swallowed by payment o fjust interest on (government) debt. Another 20% goes on subsidies and duringthe reformperiod, however, was characterized by a clear divide inthe mid-1990s inthe attainment o f fiscal targets. There was evidence o f the successful fiscal correction during 1991/92 to 1996/97 (except for 1993/94) in terms o f a significant fall in the fiscal deficit and in public debt as a proportion o f GDP. Since then there has been a significant reversal o f trend. Indeed, many deficit indicators presently are persisted, but has grown in size duringthis period. ...... Several pointers indicate a reversal o f the fiscal even higher than the levels prevailing at the time o f the crisis in 1991. The revenue deficit has not only consolidationprocess inthe recent years. These include decline intax to GDP ratio, downward rigidity in current expenditure, steady deterioration in public investment in productive sectors, slow progress o f PSUs restructuringand faster accumulation o f public debt." 2.27 Inview o f the preceding analysis, fiscal reforms are needed to ensure a phased reduction inthe primary and revenue deficits of the center and state governments, and to reallocate expenditure toward more productive uses. Following are proposals for policy reforms in four key areas: (a) tax reform; (b) subsidy reduction; (c) financialpolicy; and (d) fiscal management. TaxReform 2.28 The gross tax revenue o f the central government fell from 10.3% o f GDP in 1991/92 to 8.6% in 2001/02.32 The goal i s to raise taxes back to 10.3% o f GDP by the end o f the Tenth Plan. Plan projections assume a big increase in tax buoyancy from 0.8 during the Ninth Plan to 1.26 during the Tenth. Most o f this increased buoyancy i s expected to come from indirect taxes, customs duty in particular. Achieving this goal rests on several key assumptions: (a) complete withdrawal o f import tariff exemptions (except on strategic imports); (b) a strong resumption o f manufacturing sector growth, as this sector has the highest tax buoyancy; and (c) extending the tax net to include the booming services sector. The states' own tax collection i s projected to be raised from 5.9% o f GDP inthe base year to 6.6% by the end o f the TenthPlan. This increase crucially rests on the implementation o f a unifiedVAT covering all goods and services. 2.29 While the decline inthe tax-to-GDP ratio duringthe 1990s i s partly due to the "costs o f reform", which reflects the reduction incustoms and excise duties to increase competition and enhance efficiency, it also reflects the costs of incomplete reform. The shift towards direct taxes has failed to fully compensate for the reduction in indirect taxes implemented as part o f the reforms duringthe 1990s. As the Kelkar Committee reports33emphasize, the lowering o f tax rates needs to be complemented with the elimination o f exemptions, the bringing into the tax net o f services and agriculture and improved information technology-based tax administration. These reforms deserve the highest priority in view o f the decline in the tax/GDP ratio duringthe 1990s and the direct positive effect this will have on reducing 31TimesNewsNetwork, Times of India, New Delhi, March 14,2003. 32Tenth Plan, Chapter2, paragraph2.110. 33Reportof the Task Force on DirectTaxes, Reportof the Task Forceon IndirectTaxes, MOF, December2002. 21 primary and revenue deficits. In this respect, while tax administration has been given due prominence in the UnionBudget for 2003/04, there has been a tendency to increase exemptions and special rates, even in excise despite the rationalization o f main rates; and there has been no move to tax agricultural income, which will perpetuate incentives to disguise non-agricultural income as agriculturalincome. SubsidyReduction 2.30 Subsidies. Table 2.6 presents trends in explicit subsidies o f the central government. Inaddition, implicit subsidies as a result o f below-cost power tariffs are also presented. The central food subsidy amounted to Rs.242billion with fertilizer subsidies adding another Rs.110billion, a total o f 1.4% o f GDP in2002/03. Foodgrain and input subsidies have distorted farmer cropping and investment decisions and thereby contributed to natural resource degradation (soil nutrient imbalances, water logging, salinity, etc.). At the same time, public investments in agriculture over the last decade have declined inlarge part due to the pressing need to meet subsidy requirements in the foodgrain, fertilizer, irrigation, and power sectors. The main reform goal therefore would not be to achieve fiscal savings, but higher growth in agriculture by shifting central expenditures from food (subject to the maintenance o f a minimum social safety net) and fertilizer subsidies towards productivity-enhancing investments, including imgation, rural infrastructure, and research and extension. These issues are taken up in Part I11.2 o f this report. The petroleum subsidy amounts to about 0.4% o f GDP and i s to bephased out over the mediumterm. Table 2.6: Government Subsidies 97/98 98199 99/00 00101 01/02 02/03 03/04 RE BE (Rs billion at currentprices) Food (incl sugar) 79.2 92.1 94.8 121.0 175.1 242.0 278.0 Fertilizer 99.2 116.0 132.4 138.0 126.0 110.1 127.2 Petroleum 62.7 81.2 Interestsubsidies 0.8 14.3 13.7 1.1 2.1 7.7 1.8 Others 6.2 13.6 3.9 8.3 8.9 23.8 10.9 Total subsidies 185.4 235.9 244.9 268.4 312.1 446.2 499.1 % GDP Food (incl sugar) 0.5 0.5 0.5 0.6 0.8 1.o 1.o Fertilizer 0.7 0.7 0.7 0.7 0.5 0.4 0.5 Total subsidies 1.2 1.4 1.3 1.3 1.4 1.8 1.8 Memo (%) Food (incl sugar)/GFD 10.7 9.5 8.9 10.0 12.1 16.3 16.7 Food/Revenue 5.9 6.2 5.2 6.3 8.7 10.2 10.9 SEB IosseslGDP 0.9 1.2 1.4 1.2 1.4 Source: Governmentbudget documents(variousissues),Annual Performanceof SEBs, PlanningCommission(several issues) 2.31 Power sector reform. This is a key reform for both fiscal sustainability and spurringgrowth by more efficient provision o f power services to industrial and commercial users and more reliable supply to the rural areas. Estimated SEB losses in 2001/02 were Rs.332 billion, approximately three times those in 1996/97.34To put this inperspective, the gross fiscal deficit o f the states was 4.4% o f GDP in2001/02, or about Rs.1183 billion. Subtracting from this the actual subsidy paidby the states to SEBs o f Rs.83 billion gives a fiscal deficit net o f the subsidy o f Rs.1100billion. This means that ifthe total losses o f SEBs are consolidated with the fiscal deficits o f the states, these would rise on average by 30%. Given the low ~~ 34 Source: Planning Commission, Govemment o f India: Annual Report (2001-02) on the Working of State Electricity Boards & Electricity Departments, May, 2002. The actual financial loss is even greater because of collection problems. 22 level o f the actual subsidy received, SEBs have been defaulting on their payments to central government agencies (suppliers and lenders) to finance a part o f these losses. Bond issues by SEBs guaranteed by the state governments, which are rapidly adding to the contingent fiscal liabilities o f the states, are another source o f finan~ing.~'SEBs have also been "borrowing" from their own employees by runningarrears on related pension and PF obligations. A consequence has been inability to maintain SEB assets. 2.32 SEB operations also entail significant T&D losses (technical as well as commercial losses and theft) which in some states are as high as 40-50%. Owing to poor collections, outstanding receivables o f various state utilities have grown from Rs.145 billion in 1996/97 to Rs.248 billion in 1999/2000. Tariffs covered only 68% o f the cost o f supply in 2001/02. At the same time, there i s highdispersion in tariffs, with commercial and industrial users cross-subsidizing agricultural and domestic consumers and being charged rates far in excess o f the cost o f supply. As a result o f this and the poor quality o f supply, many manufacturing companies install their own generators. Moreover, recent studies show that subsidies are regressive and the poor benefit little from subsidized electricity, either in urban or rural areas, providing littlejustification for continued subsidies to consumers. 36 2.33 The financial and social case for reform is clear, as are the essential elements. Average tariffs need to be raised to reflect cost o f supply; universal metering o f consumption i s required, especially for agncultural and domestic consumers; payments discipline needs to be enforced; and a targeted subsidy scheme needs to be introduced for poor households and farmers so that the cross-subsidy burden on industrial and commercial users can be eliminated. It i s also accepted that there will be greater incentive to sustain reform with privatization o f the distribution business. However, political will has often been found wanting especially in raising tariffs for farmers, or implementing better governance. The fundamental problems affecting the sector stem from the apparent unwillingnesso f the state and central governments to allow the sector to function along commercial and economic lines. Go1 has recently initiated a few potentially decisive steps to give stronger incentives to states for reforming their power sectors. For these to work, privatization o f distribution, stronger action on tariffs, governance improvement and financial restructuring are needed. 2.34 Parliament has passed a new Electricity Act, while M o F has instituted the Accelerated Power Development and Reform Program (APDRP) in support o f power reforms. Other measures include the work o f the Deepak Parekh Committee on state-specific reforms, and decisions to rate SEBs by independent rating agencies. The Ahluwalia Committee had recommended that the past-due arrears o f SEBs to central govemment agencies, which amounted to Rs.415 billion at the end o f February 2001, be compensated by bonds issued by the respective state governments, guaranteed by Go1and carrying a tax- free interest rate o f 8.5% per annum.37 A tripartite agreement involving RBI, state governments and the Ministry of Power was signed in March 2003 in this regard. Under this agreement, state governments have also agreed that in case o f default o f SEBs on payments o f bills to central agencies, RBI would deduct at source a corresponding amount due to the states. While initial signs are encouraging, the effectiveness o f this agreement in imposing a hard budget constraint on states, and thereby providing a stronger incentive for reform, will depend on its continued enforcement by GoI. APDRP i s another potentially effective step. However, for APDRP to provide incentives to states for reform, the scheme needs to clearly link assistance strictly to tangible and irreversible measures on reversing SEB losses and improving governance. Without such linkage, APDRP may weaken the resolve to reform. Financial Policy 2.35 Since 1992/93, varying but relatively small sums o f money have been spent to assist nationalized banks, regional rural banks, UTI, IDBI and IFCI, with another 0.8% o f 2002/03 GDP identified to help UTI, IFCIand IDBI. The banks' reported gross non-performing loans (NPLs) were 10.4% o f loans as of 35 Credit Rating and Information Services of IndiaLimited(CRISIL) (2002). 36 World Bank (2001b) and (2002j). 37 Report of the Expert Group, Settlement of SEB Dues, May 2001. 23 March 2002; net o f provisions the figure was 5.5%; and net non-performing loans as a percent o f assets were 2.3% or about 1.5% o f GDP. While some financial analysts have suggested that N P L s are substantially understated by various "evergreening" methods, a doubling o f the gross figure would putnet NPLs at less than 7% o fbank assets, or about 4.5% o f GDP. Another indicator o frisk, lendingfor stocks, real estate, and commodities, i s less than 4% o f lending. While off-balance sheet operations are equal to nearly 60% o f the balance sheet, three-fourths are forward exchange contracts (half by the foreign banks) mostly relatedto exports and imports and often with RBIas the co~nter-party.~~While these numbers are low in comparison with East Asia and China, this has to be looked at in the context o f public sector debt that i s over 90% o f GDP inan environment o f worsening government debt dynamics. 2.36 There are two key r e f o m issues. The first i s how to enhance the role o f the financial system in efficient resource allocation. The second i s how to minimize risks. The first topic i s closely related to the fiscal stance. So long as deficits are high, a highproportion o f bank assets will be investedin government debt. As o f March 2002, about 28% o f bank assets were invested in government debt and another 5.6% was with the RBI. Indian banks have one o f the highest ratios o f government debt to deposits in the world, similar to Latin American countries and muchhigher than most East Asian comparators, even after the crisis. A fiscal adjustment would clearly help and also relieve crowding out. 2.37 Measures are also needed to contain risk and manage NPAs. In this connection, the new Securitisation and Reconstruction o f Financial Assets and Enforcement o f Security Interest Act (2002), which allows banks to take over collateral more easily, could push debtors to pay up. Similarly, establishment o f Credit Information Bureaus should help in sharing information on credit risk, which would lower transactions costs while also helpingto control NPLs. It would particularly help with SMEs, which at present suffer fiom very highreal lending rates owing to the perception o f highrisk, as noted in Mohan (2003). One topic that i s relevant at present i s interest rate risk. Financialinstitutions which have investedinlong-term government paper have been making large trading profits as interest rates continued to fall, butnow face risks from the possibility o f rising interest rates. Inan attempt to counteract this, RBI has issued a directive on creating an Investment Fluctuation Reserve. While banking regulation has improved, some o f this has been offset by easing regulations to encourage restructurings and lending for housing and infrastructure, which i s beset by a weak fkamework for user charges. 2.38 Insurance and provident funds are heavily invested in government debt, and will face losses as interest rates rise. Moreover, state provident funds have also invested in special purpose vehicles (SPVs) guaranteedby the state. Many o f these assets are now no longer earning interest, making the performance of the state provident funds even more dependent on debt servicing by cash starved states, now that the guarantees are beginning to be called. The ability o f these provident funds to meet their obligations i s likely to affect public confidence in government debt issues more broadly. Finally, the administratively set returns on the provident funds are significantly above market rates, which encourage the management to engage inrisky investments inthe non-regulated portion o f their portfolio and, more generally, create a potential contingent liability for the central and state governments along the lines o f UTI. Linking rates on the provident fund more closely to the market, and reducing the role o f administratively fixed rates, would help control the continued build-up o f these problems. A similar link to rates on small savings would save interest costs for states. 2.39 Guarantees. A critical issue at the state-level pertains to contingent liabilities stemming fkom borrowings o f parastatals guaranteed by state governments. According to a recent study, such guarantees have risen sharply after 1996, mostly in connection with borrowings by State Electricity Boards (SEBs) and special purpose vehicles (SPVs) established in connection with large irrigation project^.^' CRISIL estimates that o f the market borrowings by state-level entities guaranteed between 1995 and 2002, Rs.440 billion will be called over the next five years. While this may not seem much, this estimate excludes 38While not a serious issue at present, this couldpotentially encumber RBIreserves and bears monitoring. 39CRISIL (2002). 24 guaranteed loans from banks/FIs such as NABARD,HUDCO, LIC, NCDC, REC, public sector banks and regional rural banks. Moreover, the guarantors themselves, i.e., the state governments, are already heavily indebted. N o t surprisingly, the spread on state guaranteed bonds relative to central government securities widened from 2-2.5% in 2000 to over 4% in 2002. Another problem i s that even when state- guaranteed bonds are not being serviced, creditors do not treat this as an NPA unless the guarantee i s invoked and payment not received for two quarters after this. There i s reluctance to invoke guarantees and so defaults remain hidden, adding to the uncertainty and instability. Given the extensive list o f creditors, a default will hurt the integrity and credibility o f public institutions. There i s need for a clear and transparent framework for guarantees to contain the problem. One idea i s to create a guarantee redemption fund4', though the question i s how this will be funded given fiscal constraints. Besides, it will work only inconjunction with a correctiono f the fundamental problems inpower and irrigation. Fiscal Management 2.40 There i s growing recognition that to improve fiscal policies fiscal institutions need to be strengthened. This will require changes at the central level, the state level, and in center-state fiscal relations. The central government needs to lead by example, by getting its own house in order and providing the right incentives for fiscal adjustment at the state level. At the same time, it needs to give states sufficient flexibility to use their limitedresources efficiently. 2.41 Legislating for fiscal prudence. The Fiscal Responsibility and Budget Management Bill (FRBM),passedby the Lok Sabha (lower house o fparliament) inearly 2003, mandateselimination ofthe center's revenue deficit by March 2008. The FRBMpertains only to the central government, but three states - Karnataka, Punjab, and Tamil Nadu -- haveso far passed similar Acts to limit their own deficits, and others are following suit. The proof o f the usefulness o f these pieces o f legislation will be actual progress towards their fiscal goals. A useful feature o f these Acts i s the requirement that the central and concerned state governments annually publish multi-year fiscal strategies, that is, develop time-bound road maps for restoring fiscal sustainability, and publicly monitor progress against these. This exercise has the potential o f enhancing the credibility o f India's fiscal policy if carefully implemented. 2.42 State borrowing. While states will ultimately have to be responsible for their own fiscal adjustment, reforming the borrowing regime within which they operate ("hardening their budget constraints") will also help induce fiscal reform. Global borrowing caps - covering both on-budget borrowing and off-budget borrowing through state-level public enterprises and special purpose vehicles the debt-servicing o f which becomes a contingent liability o f the budget - should be introduced and enforced by GoI, usingpowers under Article 293 o f the Constitution (for progress to date in this regard, see the next paragraph). In return for much tighter control by Go1 over the total annual quantum o f borrowing, states could be given much greater freedom over how they arrange that borrowing. States should be allowed to borrow responsibly from the markets within their global cap, and borrowing from captive sources - small savings, negotiated loans, Go1 loans - should be phased out. If necessary, a safety-net for uncreditworthyborrowers can be provided. 2.43 Performance and reform-based transfers. The volume o f center-to-states transfers linked to reform and performance needs to be expanded. Inthis regard, the creation o f the Fiscal Reforms Facility (FRF), as per the recommendation o f the Eleventh Finance Commission, and the APDW for the power sector are steps in the right direction. The Fiscal Reform Facility provides grant funding for states which reduce their revenue deficit as a ratio o f revenue receipts. Though the funding attached to the FRF i s small given its universal coverage (only 2% o f all transfers to the states), it has had a significant impact. First, it has required states to draw up "Medium Term Fiscal RestructuringPlans" (MTFRPs) which, for the first time, have placed fiscal policy at the state-level in a medium-term strategic framework. Second, the borrowing levels agreed on under the MTFRPs have started to take on the nature o f global borrowing 40RBI(2003e). 25 caps, and thus have helped Go1to start to discipline state borrowing in an environment characterized by multiple borrowing windows. (Less progress, however, has been made in preventing states circumvent central controls o n budget borrowing through use o f off-budget special purpose vehicles. Orders issued by Go1and RBIseemto have hadlittle impact inthisregard.) In2002/03, the FRFalso started to provide authorization for qualifying states to borrow additional funds from the market. Multilateral agencies also provide financing to reforming states through GoI. It would be useful for assistance to fiscal reformers to be passed on as grants to states, rather than loans, both to increase the incentives for reform, and to help such states reduce their debt burden. Public reporting o f access by various states to reform facilities and reasons for both access and denial to access will help ensure transparency and consistency. 2.44 Measures to simplify expenditure management. While India's five-year plans help provide a strategic framework for development efforts, the division o f budgetary resources into "plan" and "non- plan" i s increasingly recognized as counter-productive. It adds complexity to the budgetingprocess, and also perpetuates a perception that plan spending i s always better than non-plan, and should always be increased. This militates against fiscal correction, and leads to chronic under funding o f maintenance (non-plan) relative to capital spending (plan). Unfortunately, substantial Go1 assistance i s provided for state plan spending mahng elimination o f the planlnon-plan distinction at the state level a complex and unpopular proposition. But Go1could take the lead by abolishing the distinction at the central level. Go1 could also propose to states that its financial support to them would be delinked from their annual plans. Fundingcurrently provided as plan support would be provided on the basis o f an agreed and explicit set of criteria - which initially could be based on those currently in place - but could be termed "development support" rather than "plan support". Any such move would require consensus among states to succeed. Go1 could help build this support by announcing that this move would enable funding for non-plan areas, such as maintenance. 2.45 Centrally Sponsored Schemes (CSSs) are provided by Go1 to the states, largely (though not entirely) as grants, for the achievement o f national goals such as poverty alleviation and universal enrollment. However, they have tended to proliferate, and there are now more than 300, leading to budgetary rigidity and poor implementation at the state level. A practical solution would be to consolidate the CSSs into a smaller number o f programs, with a minimum size, and flexibility for the states to mthese as per their needs and priorities. Some central ministries have already moved in this direction by adopting a cafeteria approach whereby a cluster o f CSSs are clubbed together under one umbrella scheme and the selection o f individual schemes from this cluster i s left to the states. GovernmentDebtProjections: Why FiscalAdjustment? 2.46 The case for fiscal adjustment i s illustratedby general government debt projections to the end o f the Tenth Plan period, 2006/07, under a base-case scenario o f "no reform" versus a "reform" scenario. In both scenarios, the debt trajectory i s driven mainly by the primary (non-interest) fiscal deficit as, based on actual developments in recent years, interest rates are unlikely to be substantially below growth rates, absent an undesirable reversion to financial repression. However, given the extraordinarily low interest rates because o f the weak global economy, it i s assumed that real interest rates remain below the growth rate for a year or two, depending upon the scenario (even though, as noted above, the average interest rate on government debt has been close to or above growth rates for the past four years). Two other factors deserve emphasis: extrapolating from current trends, the pressure to fully absorb SEB losses into state fiscal deficits will grow, effectively raising the general government primary deficit by this amount; and it would be prudentto assume that guarantees, which amounted to 12%o f GDP in2002/03, and which have generally been made in support o f loss-malung enterprises, will devolve at the rate o f 1% o f GDP per year over the projection horizon.41 41Note that this assumption pertains only to the existing stock of guarantees, and does not take account of any new guarantees which may be issuedafter 2002103. 26 2.47 An implication o f the above is that ifthe goal i s to either stabilize or reduce the debt/GDP ratio, generating primary fiscal surpluses i s a must. Therefore, the focus o f reform will have to be on cutting the primary deficit andraising growth. Moreover, it i s envisaged that the cut inthe primary deficit will be achieved without reducing capital expenditure. Thus, cuts in the primary deficit will automatically mean cuts in the revenue deficit, improving the quality o f public spending. However, as discussed below, the net impact on the revenue deficit will also depend upon the path o f interest payment~.~' terms o f fiscal In measures, revenue mobilization needs to be given top priority, as in a comparative international context, revenues are l o w and debt i s high while spending i s roughly in line with other countries.43 The major policy levers flowing out o f the preceding analysis are raising tax revenues, reducing SEB losses and eliminating the petroleum subsidy, supplemented with structural reforms to spur growth. The base case assumes that fiscal and structural reforms will proceed slowly or not at all, while the reform scenario assumes a systematic plan to implement the needed fiscal and structural reforms over the Tenth Plan period. Box 2.1 summarizes the assumptions underpinningthe two scenarios. Box 2.1: Assumptions Underlying DebtDeficit Projections The initial level of general governmentdebt i s 85.6% o f GDP, its level at the end o f 2002/03, (including about 0.8% o f GDP proposed for bailouts inconnection with UTI, IDBIand IFCI). The primary deficit o f the general government stays at 3.5% o f GDP in the base case, a little below its average level over the past six years.44 Inthe reform scenario, the primary deficit goes down linearly from 3.5% o f GDP to 0.7% by the last year. This comes from raising central government revenue by 1.7 percentage points and state revenues by 0.7 percentage points by the terminal year as envisaged in the Tenth Plan document; and eliminating the petroleum subsidy o f 0.4% o f GDP. It i s assumed that taxes rise as a result o f eliminating exemptions, widening the tax net to include services and implementing the state VAT. Food and fertilizer subsidies amount to about 1.4% o f GDP. Under reforms, 0.5% of GDP is maintained as a minimumsocial safety net; the balance o f 0.9% i s phased out while productivity-enhancing investments in agriculture, such as rural infrastructure and research and extension, increase by the same amount. There i s no change inthe base case. SEB losses remain 1.5% of GDP in the base case and go linearly to zero by the terminal year as a result o f aggressive power sector reforms inthe reform scenario. Divestmentreceiptsremain 0.5% of GDP inboth scenarios. Guarantees (contingent liabilities, CL) accumulated as o f end 2002/03 devolve at the rate o f 1% of GDP per year in both scenarios. Growth, realinterest ratesand inflation(%) are as follows: 45 2003104 2004105 2005106 2006/07 Growth (base) 5.5 5.0 5.0 5.0 Real interest rate (base) 4.0 5.0 5.5 5.5 Inflation (base) 5.5 5.0 5.0 5.O Growth (reform) 5.5 7.0 7.5 8.0 Real interest rate (reform) 4.0 6.5 7.5 8.0 Inflation (reform) 5.0 3.5 3.5 3.5 42Go1has initiated debt swaps and prepayment o f external debt in order to reduce interest payments. However, these measures are unlikely to be a substitute for a fundamental fiscal adjustment. 43IMF (2002), 111:"The Fiscal Situation inInternational Perspective". 44 The primary deficit incorporates a portion o f seigniorage in the form of RBI profits and dividends, which enter non-tax revenue. 45 The 8% Tenth Plan target would imply a growth rate o f 8.9% per year over the remaining years o f the Tenth Plan period, which seems unattainable at this point. The base case assumes a compound average growth rate o f 5% during the Tenth Plan period and the reform scenario, 6.5%, reaching 8% inthe terminal year. 27 2.48 The debt/GDP trajectory under Scenarios 1 and 2 are presented in Figure Figure2.5: Government DebtlGDPRatio // 2.5. In the base case, the general 110.0, ProjectedtoMo6107 government debtlGDP ratio reaches 107% by the end of theTenth Planperiod. Inthe 105.0 - reform scenario, it reaches 95%. These results are being driven by the general 1w.o - government primary deficit, SEB losses j 4 and the calling o f guarantees, and 95.0 underline the need for implementing fiscal and structural reforms. The broken lines are debt/GDP excluding contingent 850 liabilities, which would lower the 200203 200304 xx)4105 2005106 2036107 debt/GDP ratio to 103% by 2006107 inthe --tBaseCase ......Base case (CL-0) base case and 91% inthe reform scenario. +Reform Case -x- Reformcase (a4) S m m World Rank Stdf Fslirmfps ' 2.49 Figure 2.6 projects the general government fiscal deficit/GDP ratio under the two scenarios described above. For this exercise, the calling of guarantees is ignored in projecting debt levels and hence 14.0 interest payments. While SEB losses are factored into the projection o f debt levels 120 and interest payments, they are not included a 10.0 in the deficits shown in Figure 2.6 for n ? ao comparability with present deficit reporting +560 practices; thus, the "true" picture especially m a under the base case i s likely to be worse 4.0 than depicted in Figure 2.6 unless power 20 sector losses are aggressively eliminated. 0.0 In the base case, deficits rise steadily to 13% of GDP, as one would expect with primary deficits at 3.5% of GDP, debt exceeding 100% of GDP and nominal interest rates of some 10%. Under reforms, deficits remain inthe 10% of GDP range because of the drag exerted by the high debt stock and the impact of rising interest rates as growth picks up; deficits will decline slowly as debt levels are brought under control.46 The only sure way to bring about a faster decline i s to achieve primary fiscal surpluses. 46The deficit projections here, which are repeated inTable 2.7, are substantially higher than those reported in Table 2.5 based on the macroeconomic framework for the Tenth Plan. The reason is that Table 2.5 is formulated on the basis on either achieving debt sustainability (at a minimum)or the growth target o f 8% per annum (much more difficult); inthis sense, it embodies an ideal outcome. Incontrast, the projections inFigure 2.5 and Table 2.7 are more in the spirit o f a probable outcome given conditions at the end of 2002103 and the scenarios specified inBox 2.1. 28 2.50 Table 2.7 brings out the potential for a more efficient composition o f public spending under reform. While there i s not much difference in interest payments between the two scenarios (because o f the high level o f initial debt, the absence o f primary fiscal surpluses even in the reform scenario and similar levels o f nominal interest rates), the reform scenario permits a significantly higher level o f "other spending" (defined as total spending minus subsidies and interest) by the end o f the Tenth Plan period, While the increase in revenues (+2.4 percentage points o f GDP), elimination o f petroleum subsidy (0.4 percentage points) and reduction in food and fertilizer subsidies (0.9 percentage points) will act to reduce the general government revenue deficit by close to 4 percentage points o f GDP, interest payments are projected to rise by about 3 percentage points - from 6.5% o f GDP inthe first year o f the Tenth Plan to about 9.5% o f GDPby the terminal year, 2006/07. Thus, the net reduction inthe revenue deficit will only be about 1percentage point o f GDP; but the quality o f spending will have vastly improved. Table 2.7: Fiscal Projections (% of GDP) 2003104 2004105 2005106 2006107 2003104 2004105 2005106 2006107 Base Case Reform Case Primarv deficit 3.5 3.5 3.5 3.5 2.8 2.1 1.4 0.7 lnteresi payments 7.6 8.3 9.1 9.6 7.2 8.1 9.1 9.6 Fiscal deficit 11.1 11.8 12.6 13.1 10.0 10.2 10.5 10.3 Revenues 17.5 17.5 17.5 17.5 18.1 18.7 19.3 19.9 Total spending 28.6 29.3 30.1 30.6 28.1 28.9 29.8 30.2 Subsidies 1.8 1.8 1.8 1.8 1.5 1.2 0.9 0.5 Other spending 19.2 19.2 19.2 19.2 19.4 19.6 19.8 20.1 InterestlRevenue(%) 43.3 47.2 51.9 54.7 39.8 43.6 47.1 48.2 Source:World Bank Staff Estimates. 2.51 Three points emerge: (a) it i s not going to be easy to eliminate revenue deficits by 2007/08. Further,the focus mustbe on raisingrevenues, cutting subsidies and controlling salaries, i.e., on the non- interest component o f the revenue deficit, as there i s little or no control over interest payments. In the same vein, it may be necessary to lay down intermediate targets by specific budgetary category in the medium-term fiscal frameworks required by the central and state-level Fiscal Responsibility Acts. (b) Even under a reform scenario, the government debt burden will continue to be heavy duringthe medium term. And (c), without reform, the debt burden and ratio o f interest payments to revenues will increase quickly and fuel inflationary expectations and eventually, higher actual inflation. Private investment will be dampened if the private sector feels it is going to be taxed to service the debt, leading to anemic growth. 2.52 To conclude, a program o f progressive and phased fiscal adjustment must be a cornerstone of GoI'sattempts to spur poverty-reducing growth and avoid an unsustainable path for public debt. Even in a reform scenario, the general govemment fiscal deficit i s likely to remain inthe 10% range over the next few years, althoughwithprimary deficits more-or-less eliminated by the end o f the TenthPlanperiod, the deficit should subsequently decline as debt levels and interest payments are brought under control. The focus needs to be on tax reform and eliminating SEB losses; the re-allocation o f food and fertilizer subsidies amounting to about 1% o f GDP towards rural infi-astructure and agricultural R&E (while maintaining 0.5% o f GDP as a minimumfood social safety net) will raise development spending without a negative fiscal effect. 2.53 Fortunately, India i s not facing an imminent macroeconomic crisis o f the type witnessed in Argentina or Russia, even though it i s paying a heavy price in terms o f growth and welfare for its current fiscal stance. On the positive side, India has the time to put inplace an orderly fiscal adjustment over the 29 Tenth Plan period. At the same time, in the absence of an impending crisis, it i s hard to develop the political momentum for reform. Indeed, in some key areas, such as the power sector, there are strong political and vested interests against reform. India has clearly recognized the needfor fiscal adjustment in the Tenth Plan and in recent legislation. The challenge now is for Go1and the states to translate this commitment into an overall road map as well as specific policies for fiscal consolidation. The pay-off in terms o f freeing up resources for priority public programs and improving the climate for private investment will be well worth the effort. 30 II.2:DELIVERYOFPUBLICSERVICES Introduction 2.54 Sustained growth i s the most powerful driver o f poverty reduction. But poverty reduction also requires investment in human development. Health and education are the most important assets o f the poor, allowing them to both contribute to and benefit from growth throughhigher-paying employment. In addition, when incomes fall below minimumstandards, the poor and vulnerable need access to effective safety nets. Delivery o f social services requires increasing the level, but more importantly the quality o f public expenditures in these areas. In turn, this requires improving the governance and productivity o f India's civil service at the center, state and local levels. Inmany o f India's poorest states, such as Bihar and Uttar Pradesh, the private sector delivers health and education services to a large share o f the population, including the poor. Improving service delivery will therefore require an appropriate regulatory framework for private sector contributions inthe health and education sectors. 2.55 This section reviewsthe major challenges facing the delivery o fpublic services inIndia today. It starts by loolung at the current size, structure, cost and contribution of the civil service, and suggests a number of ways to improve the performance o f the civil service and the quality o fpublic service delivery. Critically important are reforms to improve the transparency, accountability and independence o f the civil service. A number o f states are already implementing innovative reforms in these areas, often with the aid of IT technology. The challenge will be to find ways to broaden these initiatives and apply them across the country, including in some o f the poorer states where the governance environment i s weak. This section then turns to look more closely at the situation inthe health and education sectors, as well as for social safety nets, focusing on the prospects for achieving the targets set by the Tenth Plan and the Millennium Development Goals. It stresses the importance o f harnessing both the public and private sectors to achieving social outcomes, with careful monitoring o f progress along the way. This section concludes with a few reflections on the decentralization agenda and the prospects for successful public sector reform inthe future. CivilServiceReform Size and Structure of the Civil Service 2.56 Interms o f aggregate numbers, India's civil service is not particularly overstaffed incomparison with other countries. With central government civilian employment o f around 3.4 million, estimated state employment o f around six million, and another four million or so teachers and health workers working in government and grant-in-aid institutions, India's civil service employment i s around 1.4 per 100 o f population. Although international comparisons can be tricky, the average for Asia in the 1990s was around 2.6 employees per 100, and for the OECD countries it was 7.7 per 100. 2.57 However, while India's civil service i s not unduly large by global standards, there i s a pronounced imbalance in skills mix. Around 93% o f the civil service i s comprised o f Class I11and IV employees for both Go1 and various state governments. Class I11encompasses a number o f front-line delivery workers, but also includes a large number o f office staff (e.g., clerks, typists) whose functions are rapidly being made redundant by advances in information technology. Class IV employees function entirely ina support role (e.g., peons, sweepers, messengers, watchmen), and most could be let go without any discernable impact upon government functioning. This over abundance in support and logistical personnel often exists alongside chronic shortages o f shlled staff inrural schools and health clinics. 2.58 Changes in the skills mix need to be accompanied by measures to reduce administrative fragmentation. Within Go1 and in many states, the number o f ministers, ministries and departments has proliferated far beyond any rational assignment o f functions. The number o f cabinet ministers for OECD countries has come down inrecent years to an average o f 14. GO1has 31 cabinet ministers and another 45 ministers o f state. Most Indian states have between 35-40 cabinet departments, and some states such 31 as Uttar Pradesh can have over 70. Compounding the problem are relatively weak mechanisms for policy coordination inmany states, since most departments report directly through their own minister. Nor does fragmentation end with administrative structures. Budget heads are not always closely aligned with departments. The civil service i s divided into dozens of cadres, each with its own service and terms and conditions, whose controlling authorities are widely disbursedthroughout the various departments. Rigid terms and conditions make it difficult to transfer staff between cadres where they can be better utilized. Institutional reforms are therefore needed to reduce the current administrative fragmentation and align the structure o f the civil service more closely with modem-day functions. Costs of the Civil Service 2.59 The Fifth Pay Commission has been called "the single largest adverse shock to India's strained public finances in the last decade" and an act Table 2.8: Ratio of Civil Service Salary and Dearness Allowance to GDP of "fiscal profligacy" for Go1and Selected States without - parallel (in%) (Godbole 1997, Acharya 2001). As a result, the 1995196 1996197 1997198 1998199 199912000 2000101 compensation paid by Actual Actual Actual Actual Actual Actual Go1 to civil servants GO1 1.3 1.2 1.6 1.5 1.5 1.4 (here defined as salaries Andhra Pradesh 4.8 4.3 5.0 4.7 5.4 5.5 and deamess allowance) Karnataka n.a n.a 4.9 4.5 4.8 4.4 rose by around 40% Orissa 7.0 8.3 7.6 9.1 9.2 8.6 between 1996197 and Rajasthan n.a 6.8 7.0 8.6 8.2 7.9 1997/98. Over the Uttar Pradesh 5.6 5.4 6.2 6.1 5.9 6.0 decade of the 199oS, Notes: GOI data on salaries is basedon salariesfor sanctionedstrength of central govemment employees GoI's wage bill has risen Sources: Various BudgetDocuments,Central Statistical Organisation by an average nominal rate o f 14.3% per annum, substantially higher than the average increase in the consumer price index (9.5% per annum) over this period. As Table 2.8 indicates, the situation in the states i s even more dire. Inthissample of states, which includes a mixture o f the Table 2.9: Ratio of Average Wages in the Public and Private Sector richer southem states and for Selected Categories of Employment poorer northern ones, the wage bill increased on Occupation* 1993194 I999100 average by nearly 1% o f state Professional,technicians and relatedworkers 1.52 1.72 GDP between 1996/97 and Engineers 1.07 1.34 1998/99. The example o f Engineeringtechnicians 1.3 1.27 Orissa i s extreme but not Physiciansand surgeons 1.65 2.0 atypical. During the 1990s, Nurses 2.0 2.0 Orissa's salary and pension Teachers 1.75 2.02 obligations increased 4.7 Administrative, executive and managerialworkers 1.26 1.42 times, while revenues Clerical and relatedworkers 1.6 1.74 increased approximately Stenographers,typists, etc. 1.69 2.14 threefold. By 1999/00, over General clerks (receptionist,office attendants,etc.) 1.54 1.72 180% of Orissa's own source Service workers 2.25 2.45 revenues were going to cover Sweepers,cleaners, buildingcaretakers 1.79 1.93 salary and pension expenses. All 1.92 2.33 2.60 Table 2.9 uses Notes:* Based on NationalClassificationof Occupations(ILO, 1968) National Sample Survey Data Source: Preliminaryresults basedon 50th and 55th NSS rounds,from forthcoming "Wage Differentials Between the Publicand Private Sectors in India" to demonstrate that wages for 32 selected categories o f staff are consistently higher than they could expect to make in the private sector, with premiums ranging from 27% for engineering technicians to 145% for low-end service workers. For teachers, the premium i s around This provides further evidence that, even prior to the recent salary increases, the vast majority of Indian civil servants were already well-compensated compared to other employees - a finding that helps explain the low attritionrates throughout the public sector even for highly-shlled positions. 2.61 Recent experience would suggest it may be wise to hold o f f on the practice o f holding periodic pay commissions, which has provided impetus for significant wage increases. Instead, Go1 and state govemments could opt for limited annual wage increases, or even pursue a freeze for 2-3 years, followed by a limited relaxation for skilled positions. Altematively, as recommended by the Fifth Pay Commission, the process o f constituting commissions every ten years could be abandoned in favor o f a permanent pay commission, which could continuously analyze and make recommendations regarding appropriate compensation in consultation with the states. Whatever system i s adopted, greater emphasis needs to be given to local market comparators (particularly those involving the private sector) in determining salary levels. Efforts to rationalize the number o f cadres and review the classification o f posts would also help to improve managerial flexibility and consistency between various categories o f employees. 2.62 The costs of the civil service are raised further by burgeoning pension liabilities. At the center, pension spending for civil servants increased dramatically during the 1990s, with average yearly growth surpassing 20%, and has now reached 1% o f GDP. The situation i s even more difficult at the state level. For example, in Uttar Pradesh, the ratio o f pension spending to state GDP increased from 0.4% to 1.2% duringthe 1990s. Pension expenditures at the central and state levels are likely to keep on growing at a fast pace, especially at the state level where employment more than doubled over the past 30 years. Preliminary estimates conducted in 2001 using the World Bank PROST actuarial model suggest that the present value o fcentral and state pension liabilities could amount to 25% of GDP. 2.63 Inlight of risingpensionliabilities, Go1announced inFebruary 2003 a planto establish a fully- funded defined contribution (DC) scheme for new civil servants, where individuals will be able to choose among a limited number of pre-qualified private asset managers and one public asset manager. The system will be centrally administered to reduce costs. A new specialized pensionregulatory agency will be created to supervise the new scheme.48 The shift to a fully-funded D C scheme will force the payment o f pension liabilities as they accrue, creating a more transparent and financially viable scheme. Critical design issues of the scheme are still to be defined, including the contribution rate, criteria for selecting private asset managers, and the structure o f the public asset manager to minimize governance problems, The implementation plan will also have to be carefully devised to minimize risks, and a strong and effective regulatory agency will have to be established. Since this reformwill apply to new civil servants, primarily younger workers, it will only contain pension costs over the longer term. Indeed, inthe short to medium term, fiscal outlays may rise, as Go1has to meet the combined costs o f the old and new schemes. Better measurement of the pension liabilities o f current civil servants would likely point to sustainability issues and the need for further reforms, including changes in eligibility criteria, and a possible shift of younger civil servants (on a voluntary or mandatory basis) to the new D C plan. 2.64 The proposed D C scheme for civil servants constitutes the first attempt to address the problems besetting the pension system in India. The reform faces the dual challenges o f establishing a sound a well- regulated funded pension system for new federal civil servants and, more importantly, motivation further and deeper reforms within the rest o f India's pension system. The new scheme will hopefully serve as a 47 Intemational comparisons of average primary teacher salaries to per capita GDP indicate a ration of around 5 to 1 in India compared to 1.7 ina sample of 39 Asian countries between 1970 and 1990. See Nelson (1994), pp 111-127. 48However its regulatory authorities will not encompass existing pension plans - the Employee Provident Fund (EPF), the Employee Pension Scheme (EPS) and occupational plans- that will remain unsuperviseddespite performance concems. 33 model for the states to reform their own pension plans. Some states (e.g., Tamil Nadu) are already contemplating similar changes for new entrants. Once implemented at the central level, Go1also intends to expand the new scheme to the unorganized private sector which remains uncovered by formal pension plans. While a laudable goal, it i s likely that coverage o f the unorganized sector will expand only gradually based on other intemational experience^.^^ This raises some question as to the viability o f the new scheme unless it i s able to attract a wider group o f workers, including private sector employees to participating in the EPF and EPS. At a minimum, the reform could allow new workers in the private sector to join inthe new scheme and allow others to opt out from the EPF and EPS5' The success o f this reform could well set a benchmark for deeper changes inthe EPF and EPS over the medium term. TheReturn on Civil Service Expenditures 2.65 While the odd success story may be found, as a general rule the recent wage gains were not compensated by any commensurate increase inthe overall quantity or quality o f government services. In fact, the mandate o f India's public service has been shrinkmg during this period, as governments seek to withdraw from direct involvement in economic production and focus more on playing a regulatory and facilitative role for private sector growth. 2.66 To the extent that qualitative improvements have been implemented, they have often relied heavily upon the application o f information technology to streamline and re-engineer business processes, such as the Bhoomi program for registering property records inKarnataka or the e-Seva "one stop shops" for over 40 government services inAndhra Pradesh. Even when infomation technology has made many functions redundant, civil servants and powerful unions have often extracted pledges of no job losses as the price of allowing the innovations to go forward, thereby limitingthe economy and efficiency gains to be reaped. One south Indian state, for example, computerized part o f its stamps and registration function. The result was faster client service and a reduction in turn around times by nearly half. By some estimates, as many as 48% o f the department's staff o f approximately 3,200 were made redundant by this decision, yet they are retained on the state payroll at an estimated cost o f over US$3 million per year. 2.67 Overall experience varies, but on average both Go1 and the states have successfully resisted pressure towards new recruitment during much o f the 1990s and beyond. However, even the best performers are yet to embark upon a significant program o f staff reduction. As a result, many line departments find themselves in an increasingly precarious position, with a growing proportion o f their non-planresources beingtaken up by salaries, over which they have very limitedcontrol. For example, in the Andhra Pradesh Department o f Stamps and Registration, only about 16% o f non-plan resources went to non-wage funding from 1995/96 to 1999/00. Other critical departments in Andhra Pradesh, such as those looking after primary education, spent 93% o f their non-capital budget on salaries duringthis period - to the detriment of spending on training and learning materials, maintenance, scholarships etc. Furthermore, because it i s difficult to shed labor or adjust personnel inputs,the burden o f any shocks that occur duringthe year fall disproportionately on non-wage expenditures, malung rational planning all but impossible. 2.68 Another fundamental problem haunting India's civil service i s the failure to use staff that it has productively. InUttar Pradesh, for example, the Public Works Department (PWD) has a total strength o f 77,000, including roughly 9,000 technical and 12,000 administrative staff, as well as 56,000 gang laborers. With 51laborers for every 100 km o f road, PWD has one o f the highest manual staffing ratios inIndia. Furthermore, market manual wage rates are about one thirdofPWDrates. As aresult, the cost o f keepingthis gang labor force i s substantial - in 1998/99, the actual expenditure on maintenance was 49 Inadequate coverage of the formal pension schemes also threatens to increase poverty among the elderly as informal arrangements become more strained. This raises the needto better target social assistance for the elderly poor. 50There are also concems about poor investment practices o f occupational pension schemes (in particular, self-lending to the sponsoring enterprises and related parties). Asset management under occupational pension plans could now be transferred to asset managers under the new scheme. 34 Rs. 2.8 billion, while establishment costs were Rs. 3.4 billion. As will be discussed below inthe sections on health and education, rates o f absenteeism among front-line workers are often appallingly high, with few being sanctioned or dismissed from service inspite o f chronic violations. 2.69 The burden o f weak administration falls particularly heavily on the poor, who suffer in terms o f skewed government spending, limited access to services, and employee indifference. One assessment o f spending for health and nutrition in North India, for example, revealed that out o f every Rs.100 o f expenditure, the poorest 20% o f households received about Rs.10, whereas the richest 20% received Rs.41.51 Inrural areas, only 4% o fthe poorest householdshad access to electricity and 25% had accessto drinkingwater, whereas comparable figures for the richest were 28% and 66% respectively. Innovative survey researchby the Public Affairs Center in Delhi and Bangalore reveal that the average slum dweller needed to make six trips to a government agency to resolve a particular problem, whereas the number o f trips among general households was four.52 The rate o f success was over four times higher for general households, averaging 27%, as opposed to only about 6% for slum dwellers. Improving Public Service Delivery 2.70 There are many reasons for the poor quality o f public service delivery in India. Internally, administrative structures and responsibilities are highly fragmented, while human resource management places more weight on seniority than merit. It will obviously take time to reform these long-standing structures and systems. However, experience throughout India shows that civil servants do respond to external pressure for delivery o f better services. Three key elements for success are: (a) improved public access to information; (b) strengthened accountability; and (d) independence from political interference. Recent experiments inthese areas, and prospects for further reforms, are discussed below. 2.71 Access to information. In order to demand better public services, citizens need to be better informed about service standards, norms and procedures, as well as have ready access to forms and other such material. Opening up access to information, short circuits the rent-seelung opportunities providedby secrecy. Citizens' charters are one vehicle to empower the public intheir dealings with service providers. It is important, however, that such charters be developed in consultation with major stakeholders and widely disseminated. One model charter i s that developed by the Greater Mumbai Municipal Corporation (BMC) inJune 1999, with assistance from an NGO, Praja. 2.72 NGOs can also play a vital role in collecting raw data, transforming it into usable information, creating data banks that other organizations can access, and disseminating relevant information to a wider audience through report cards, surveys and public hearings. InBangalore, for example, the Public Affairs Committee (PAC) conducted a user survey o f maternity wards that led to a major restructuring o f the service by the Bangalore City Corporation. Other NGOs have concentrated on public interest litigation to prod governments into taking action to improve the performance inlaggard services. 2.73 Several states are actively usinginformation technology to improve access to information. Tamil Nadu has placed all major Government Orders o f public interest on its website. AP's portal contains extensive information about government departments, schemes and policies; allows citizens to contact government officials directly, from the Chief Minister's office on down; and provides (initially) for limited on-line transaction processing as well. Computerization i s also being used to reengineer business processes and speed-up decision malung. 2.74 Finally, Go1 and a number o f states are promoting greater transparency by adopting Right to Information (RTI) legislation. Maharashtra's RTI initiative (2002), for example, provides for access to Cabinet-level documents (with certain narrow exceptions), the creation o f a public records commission to improve record keepingand cataloguing, an independent appeals process to the office o f the L o k Ayukta, penalties for non-compliance, and the creation o f a high-level council to monitor implementation. These See World Bank (2002a), p. 110. 52See Paul and Sekhar (1999) and Sekhar and Balakrishnan (1999). 35 initiatives will be followed closely, to see whether they can help counter well-entrenched practices and interests within the civil service to limit public access to information. 2.75 Accountability. The vast majority o f staffwithin Go1and the state governments are promotedon the basis o f seniority cum merit, which in practice means they will be promoted as a matter o f course regardless o f their performance as long as no adverse remarks are entered against them. Performance evaluation i s weak, and poorly linked to the system o f rewards and promotions. Even more problematic i s the failure to punish or weed out corrupt or incompetent officers. The process o f sanctioning malfeasance or mal-administration i s fkaught with multiple review and appeals stages, resulting in years of delay and only a minority o f cases where criminal or administrative sanctions are imp~sed.'~As a result, the average Indian civil servant has little to motivate himor her to better performance beyond their innate professional ethic, and faces only a minute risk o f punishment for unlawful or inappropriate behavior. 2.76 The Indian administrative structure was designed during colonial times to perform two functions: facilitate the collection o f revenue and preserve law and order. Govemment reporting relationships are inwardly focused and strongly hierarchical in nature, with the pivotal role being played by the district collector and magistrate. At the sub-district level, all lines o f authority flowed upwards to the D C D M , who in tum reported to his superiors in the state capital. While a host o f developmental functions have been added since independence, these basic reporting relationships have survived largely unchanged. Recently, a number o f reforms have attempted to enhance "external" accountability and customer orientation. Some, such as Madhya Pradesh, have sought to empower local communities by allowing them to recruit their own teachers through its Education Guarantee Scheme. Others, such as Janmabhoomi in Andhra Pradesh, have sought to regularly bring bureaucrats in contact with local villagers to listento their concerns. 2.77 Independent audits by the Comptroller and Auditor General (CAG) are one o f the primary institutional mechanisms for accountability o f the executive. However, the CAG mainly focuses on financial irregularities. While some performance appraisals are carried out, they rarely indicate how management can be strengthened. Discussion o f CAG reports by the Public Account Committees (PAC) o f parliament and state assemblies are not open to the public and often come with a long delay, which reduces the prospects for effective follow up. Clearly, audit procedures should be improved. But there should also be wider use o f other accountability mechanisms. The recent experience o f the L o k Ayukta (Ombudsman) in Kamataka i s one example which seems to be generating good results and may hold valuable lessons for other states (Box 2.2). The success o f vigilance and ombudsman functions i s critically dependent upon their having sufficient independence, budget and staff resources to investigate and prosecute corruption effectively. In addition, a comprehensive anti-corruption strategy should include: (a) a radical overhaul and simplification o f the procedures for imposing major and minor penalties; (b) expanded "whistleblower" protection; and (c) publication o f property and tax retums o f senior officials. Each state should be asked to pass the Corrupt Public Servants (Forfeiture o f Property) Act, which has already been drafted by the Law Commission. 53 In this regard, the comparison of Uttar Pradesh (UP)with Hong Kong's Independent CommissionAgainst Corruption (or ICAC), arguably the most effective anti-corruptionagency in Asia, is instructive. The average Hong Kong citizen is 39 times more likely to institute a complaint; the ICAC is over 240 times more likely to investigatea case during the year in which the complaint is made; and aHong Kong civil servant is 24 times more likely to be chargedwith a crime than his or her counterpart inUP. Furthermore,disciplinarycasesinUP can wind throughthe courts for as longas 20 years, anda largemajorityultimately end in acquittal. (Source: World Bank staff calculations based on annual reports for the UP Vigilance Department, the UP Lok Ayukta's Office, andthe HongKong ICAC, 1997-99.) 36 I Box 2.2: Karnataka's Lok Ayukta I The Kamataka Lok Ayukta i s probably the strongest o f all Lok Ayukta offices in the country. As in Madhya Pradesh, Kamataka has placed the Vigilance Department under the full control o f the independent Lok Ayukta, to strengthen his capacity for autonomous action. Inaddition, the Kamataka Lok Ayukta Act vests the Lok Ayukta with wide statutory powers ranging from investigating corruption to addressing citizen grievances against any public servant, including the Chief Minister. H e also has the right to initiate prosecution directly. Kamataka's Lok Ayukta i s appointed for a fixed five-year term by the Chief Minister in consultation with the Speaker o f the House, the Leader o f the Opposition, and the Chief Justice. Once appointed, he can only be removed for "proven misbehavior" or "incapacity" by the Govemor after a two-thirds majority vote in both chambers o f the legislature. The current Lok Ayukta in Kamataka has been very active in investigating corruption in health and education facilities around the state, visiting districts to hear complaints on a regular basis, unearthing large financial scams in Kamataka's city municipal corporations, and raiding regional transport and stamps and registration offices to catch people red-handed. The growing activism o f the Lok Ayukta has forced many departments to fumish effective redress to citizens to avoid further investigation and adverse media attention. The growing credibility o f the Lok Ayukta as an effective channel for grievance redressal i s reflected in the dramatic increase incomplaints injust one year from 303 inJanuary 2002 to 1,026 inDecember 2002. 2.78 Political independence. This topic i s a sensitive one, for the right to transfer civil servants i s clearly vested within the political leadership under Article 310 o f the Indian Constitution, which maintains that civil servants serve at the "pleasure" o f the ruling authorities. Yet few would disagree that this power is often abused by both civil servants and politicians -- the former in seeking prime postings, and the latter for a variety o f legitimate and occasionally illegitimatereasons. The net result in states such as Uttar Pradeshhas been a reduction o f average tenure for key senior civil service positions to less than a year. Chronic political instability in states such as UP and Manipur has led to the frequent collapse o f government, which has in turn led to a new round o f transfers as the next group o f political leaders has sought to reward supporters and put their "own" staff into place. Compoundingthis problem has been the relative absence o f effective transition mechanisms. Since most reforms in large public organizations require several years to produce results, it i s impossible for even the most capable and well-intentioned manager to implement lasting improvements under such circumstances. 2.79 A variety o f approaches have been tried to curb the problem o f excess transfers. Karnataka, for example, has created a new system o f cadre management authorities to approve transfers for the first time inIndia and postedthe number of transfers on a public website. This system has succeeded inreducing transfers below the 5% norm in most departments. The success o f these initiatives should be followed closely and extended to other states as appropriate. Health, Education and Social Safety Nets 2.80 India has made substantial progress towards achieving better social indicators over the past two decades. Official estimates o f poverty, literacy, and net enrollment rates have been improving dramatically since the 1980s. However, the rates o f improvement have not been sufficient to achieve the targets set inthe Tenth Plan or even the less ambitious Millennium Development Goals. Indeed, progress inhealth indicators has been slowing down precipitously. Infant mortality rates of 115 per thousand in the 1980s fell to 79 in 1992 (a fall o f over 30%) but only to 68 in 2001 (a further fall o f less than 15%). Furthermore, mortality o f children under five appears to have seen no improvement over the 1990s and might, ifanything, have worsened (fkom 94 in 1992 to 95 in2001). Educationindicatorshave continued to improve but, even here, there are still wide disparities across states, gender and caste in completion o f primary education. For example, illiteracy rates for men and women ages 15 to 24 have declined from 27 and 46 to 20 and 35% respectively -- substantial progress both in levels and inthe gender differential, but still with a way to go. 2.81 Making progress on aggregate indicators o f health and education in India requires improving the health and education status o f the poor. Gaps in both mortality and educational status between the poor and non-poor are striking: the 1998-99 National Family Health Survey (NFHS) indicates differences in 37 child mortality between the poorest and richest deciles o f wealth o f 100% to 400% across states with enrollment rates varying by multiples as well.54 For example, the range of under-two mortality rates from the poorest 5% to the richest 5% i s from 19% to 4% inTamil Nadu and from 12% to 6% inMaharashtra. Similarly, in education, the completion rates o f the poorest 20% compared to the richest 20% are 17% versus 78% in Bihar and 44% versus 95% in Kamataka. Since for the relatively well-off mortality rates are quite low and enrollment rates near universal, improvements in the average rates needed to reach the Tenth Plan goals cannot be achieved without directly improving the health and education status o f the poor. 2.82 Plausible rates o f economic growth alone will be insufficient to reach the Tenth Plan goals. If real GDP were to grow at 6% per annum, India as a whole and the majority o f states will not reduce infant mortality to half o f the 1990 rate nor achieve full primary enrollment by 2015. Nor can the Plan goals be achieved by simply increasing public expenditures - without complementary measures to improve the effectiveness o f public service delivery. This conclusion i s corroborated by analyses o f the National Family Health Survey that show that the presence o f public health care facilities in a village has no effect on mortality, controlling for income, education, access to good roads and water supply.55 While the effectiveness of public expenditure in education i s better, higher spending i s still not enough to achieve universal enrollment, let alone completion o f lower primary education. 2.83 Public expenditures on health and education have increased over the past decade. However, because both health and education are labor intensive, the bulk o f this increase has been due to sharp increases in wages o f public service providers, following the FifthPay Commission recommendations in 1997. The impact o f the Commission's recommendations on spending was somewhat higher ineducation and health than in other sectors. In some states the wage bill has topped 90% of the total costs. Figures 2.7 and 2.8 show the growth o f real spending in these two sectors with noticeable increases in the years immediately following the pay decision. The increase inthe wage bill following the Commission decision led to increases in pay rates and not to numbers o f teachers, doctors or nurses. As Table 2.7 above showed, this led to a further widening o f the gap in pay between public and private doctors and teachers (though not nurses) all three professions now receiving twice the private pay while inpublic service. This spending increase was not likely to, and indeed didnot, leadto improved health or education outcomes. Figure2.7: PublicExpenditureson Education Figure 2.8: Public Expenditures on Health (centerand states, in billionrupees ai 1993 prices) (center and states, in billion nipees at i993 prices) cIc/ 400 - 1 m MO 1004 ",i :j , , , , , , , , ~ 0 1991192 1992193 199394 1994.85 1995196 1996/97 1997198 199W9 19S3EU 1991192 1992193 1993194 1994.85 1995196 1996197 1997198 199853 19S3DQ Soum. Abusaleh ShariH,Prabir K. Ghosh, S a mK Mondal,'Indian PublicExpeodituresMSmal Seclw and PovettyNleviabm Rqrams duringthe 1993s'. NCAER,Wwking Paper 163, March2002 54These analysesare presented inWorld Bank (199%) andWorld Bank(20021). s5Ibid. 38 2.84 The essential weakness in the social sectors i s in the implementation o f good policies. The quality o f services needs to improve. As one indication, recent estimates o f absenteerates for teachers and providers are presented in Table 2.10. The problem, besides being Table 2.10: Absence Rates from Primary Facilities in Selected highoverall, is generally muchworse in States, 2003 poorer states. InBihar, for example, (in %) surprise visits to schools indicated that as many as 26% o f the teachers were Primary School Primary Health Care not present and for medical Teachers Workers practitioners, the rates are more than Andhra Pradesh 31 n.a twice as high. Since these people are Assam 31 58 on the payroll, it should not be Bihar 26 58 surprising that public money does not Gujarat 21 52 translate directly into better outcomes. Haryana 19 35 Ifvacancy rates (positions unfilled) are Karnataka 23 43 included, the bias against poor people i s Kerala 18 n.a even more pronounced. These and Orissa 14 35 other indicators o f low quality are not Punjab 18 n.a lost on the public. Bypassing free Rajasthan 23 39 public Services to Use the private Sector Tamil Nadu 17 n.a i s common, even among the poor. Data Uttar pradesh 26 42 from the National Sample Survey o f Uttaranchal 25 45 1995 indicates that more than half o f WestBengal visits to medical providers by people in Notes: 21 43 -not available the poorest quintile inrural areas are to Source: World DevelopmentReport, 2004 "MakingServices Work for Poor People" the private sector. Similarly, the use o f private schools i s increasing rapidly in general and to some extent among the poor. English medium schools, particularly, are seen as a means o f upward mobility. 2.85 The root cause o f the implementation problem i s that the government (both politicians and bureaucrats) i s not accountable for social outcomes -- the health status o f the people, learning by students -- and do not hold personnel providing the service accountable either. Incentives to public providers are not such that anyone feels responsible for better or worse outcomes. Components o f the problem are: (a) there are systemic reasons why the interests o f the poor are not reflected in policy decisions regarding health and education. Influential urban and wealthier constituencies, for example, don't consider reaching remote areas or handling disease problems that mostly affect the poor as highpriorities. The building o f facilities carries with it political benefits o f beingvery visible and having opening ceremonies but basic public health activities such as hygiene, education or mosquito control are not as beneficial to politicians; (b) policy makers have insufficient means o f influencing the incentives facing service providers. As in the general discussion o f civil service reform mentioned above, the weakness o f administration -- in this case illustratedby the lack o f control over staff behavior -- hurtsthe poor and denies them basic services; (c) the influence o f parents and patients on public providers (as in monitoring and sanctioning) i s not effective enough to compensate; and (d) the intrinsic motivation of providers, while strong, i s not sufficient to meet social objectives. 2.86 One way to make outcomes more o f a motivating factor in service delivery i s to generate and disseminate information regarding progress in services. Parents and patients should know what they are entitledto and have a place to lodge complaints when they are not received. Public officials should know whether the public is satisfied or not. Providers and policy makers should know (and be constantly learning) about what works. This requires outcomes to be more regularly measured and their determinants analyzed. One critical role o f the central government, when states have the primary responsibility for the delivery o f publicly-funded services, i s to be an independent source for this 39 measurement. Initially, measurement o f outcomes may just be for information and the sake o f openness. Over time, such measures could be used to hold states accountable for improvements - perhaps to the extent o f conditioning fiscal transfers on progress. The increase in expenditures shown inFigures 2.8 and 2.9 didnot translate into better social indicators-primarily because the spending was simply an increase inpayments for inputsrather than outcomes. 2.87 Centrally Sponsored Schemes could also be made more flexible, and in many cases, such as preventative health care, their functions and funding should be at least partially passed on to the states. What works in Kerala may not work in the north. Measures to ensure ownership, political independence and conscientious behavior o f civil service staff may be unnecessary in states with a track record o f good governance. It i s in the experimentation that such flexibility allows, that solutions to the problem o f implementation can be found. CSS should also be evaluated rigorously, based on survey data. Lessons learned will help all states improve their programs. Hence the benefits will spread wider than the state level, warranting central government involvement. 2.88 Creating institutions and establishing the measurement and evaluation procedures that will yield more effective policies and better social outcomes will take time. The solutions will also vary by sector. The following sections look at the key problems and strategies for dealing with them in the health and education sectors, and for social safety nets, as well as some proposals for improving policies inthe short to medium term. Health Strategy and Policy Priorities 2.89 There are two deep problems in the health sector: a lack o f realism concerning the public sector's role inthe health system, and a lack o f prioritization o f the public sector's possible contributions. There i s a strong tendency in the public sector (and much o f public discussion) to believe that provision in government facilities i s the whole o f the health sector. Infact, in terms o f expenditures on health, it i s only about 20% o f the total. The share i s even less in terms o f number o f visits to providers, since the public sector i s more prominent in expensive hospital care than it i s in primary care. There i s also a strong tendency inthe public sector to believe that the clientele o f the public sector i s predominantly poor. Infact, theusageofthepublic sectorismuchgreater for therelativelywell-off. Notonly aremostpublic inpatient services (over 65%) used by the richest two quintiles o f the population (compared with 19% for the poorest two quintiles), but outpatient services as well (though to a lesser degree - 48% for the better o f f 40% of the populationversus 31% for the poorest 40%).56 2.90 Intemational comparisons with a select number o f comparators support the observation that India's health system i s dominated by the private sector (Table 2.11). India's public expenditure on health reflects its low income. International comparisons over a larger range o f countries show public health expenditures to be highly correlated with income - shares o f total income going to public health spendingincreases with income itself. More unusually, private spending on health care is highas a share o f income even in comparison with such countries as Thailand and Malaysia that are significantly richer. This indicates a substantial demand and willingness to pay for health care that should be kept inmindas financing options are considered. ~ 56 See Ajay Mahal et a1 (2001). 40 Table 2.11: Health Spending in India and Comparator Countries GDP per capita Total health spending Public health spending Private health spending (US$, 2001) as a % of GDP as a % of GDP as a % of GDP India 460 4.9 0.9 4.0 Indonesia 690 2.7 0.6 2.1 Brazil 3070 8.3 3.4 4.9 China 890 5.3 1.9 3.4 Pakistan 420 4.1 0.9 3.2 Malaysia 3330 2.5 1.5 1.o Thailand 1940 3.7 2.1 1.6 Mexico 5530 5.4 2.5 2.9 Russia 1750 5.3 3.8 1.5 South Africa 2820 8.8 3.7 5.1 Source:World Bank,World DevelopmentIndicators,2003 2.91 Many factors, most outside the health sector, contribute to health status. Clean water, sanitation, and efforts to reduce indoor air pollution are all essential for a healthy environment (Box 2.3). Education (probably o f women more than men) as well as income, particularly through nutritional status, also have a strong impact. Government programs to improve health outcomes need to reflect the priority for clean water, sanitation and clean air, as well as improvements in simple medical care. Improvements in both sanitation and simple medical care are essential to achieve substantial reductions in child mortality. Although the situation i s improving, 64% o f households still have no toilet facilities. 2.92 Most medical care i s now given in the private sector and, for the poor, by very poorly or untrained practitioners. There is, however, no way to expand free publicly-supplied medical care to replace these practitioners. With limitedfunds, and more importantly with the difficulties o f managing a dispersed network o f primary health centers with personnel who do not want to live in rural areas, replacing a private market i s a low retum activity, and thus should be a low priority. Therefore, while there i s room for expansion o f health expenditures as India grows, it i s important that the extra spending complement private expenditure rather than displace it. Improving the private market public information and accreditation -- -- throughtraining, i s a better option. Over time, public financing o f private provision couldbe increased. Such an effort should be subject to evaluation to make sure it works. 2.93 Attracting private investment into hospitals i s also a way to expand services. This i s a complex issue since its ultimate success will depend on the establishment o f payment mechanisms, such as insurance, that will allow payment to private facilities. While reform proposals are being actively pursued, there i s likely to be substantial learning about the difficulties o f establishing payment mechanisms from social insurance funds and subsequent revision o f policies. It may take considerable time to establish such mechanisms and will proceedfaster insome states where financial accountability is easier to establish than in others. In the meantime, a clearer regulatory structure for the hospitals themselves would help. Even with the establishment o f insurance or other payment systems, explicit subsidies for poor patients will be necessary. And before such systems take effect, ensuring better access to catastrophic medical care for the poor i s a priority. This may, however, be related to better roads, communications and administrative procedures for admission than to increases infacilities themselves. 41 Box 2.3: Building a Healthy Environment Water, sanitation and hygiene: Adequate water and sanitation are central to improving health outcomes. Contaminated water can lead to water-borne illnesses such as viral hepatitis, typhoid, cholera, dysentery and many other diseases that cause diarrhea. Indians lose 22 million Disability-Adjusted Life Years (DALYs) annually to diarrheal diseases, making it the second-lugest contributor to the country's disease burden (WHO 1999).57 Diarrhea and other diseases caused by insufficient water quality are estimated to be responsible for approximately 1.5 million deaths per year among children inIndia (Parikh et a1 1999). Inadequate quantities o f water prevent sufficient personal hygiene, facilitating the spread o f many diseases and infections. Although water quality is important, multi-country studies have shown that improved hygiene through hand washing and sanitation through latrine usage have a greater impact on health outcomes. Hygiene and sanitation improvements reduce diarrhea, parasitic infections, morbidity and mortality more than water quality (Esrey et a1 1991, Hutley et a1 1997). Although there has been significant effort in India to provide water supply, sanitation coverage has lagged behind. Greater access to sufficient quantities of clean water and the promotion of sanitation and hygiene would reduce the burden of water-bome diseases. However, infrastructure alone will not necessarily decrease child mortality in poor families, which tend to be most vulnerable to disease. Piped water leads to improved child health outcomes in India, but the gains tend to be lower for children with less educated mothers and less wealthy families (Jalan and Ravallion2001). This points to the importance o f combining education and poverty reduction strategies with infrastructure investment to protect the health of children in India. Indoor air pollution: Although water pollution and inadequate sanitation plague many countries, indoor air pollution is a larger problem in India than in most parts o f the world. Smoke emissions from the use o f biomass fuel (wood, dung, and straw) are estimated to be responsible for about 500,000 premature deaths as well as about half a billion illnesses each year (World Bank 20021). Young children, who spend much of their time at home, are particularly vulnerable to the health consequences o f exposure to smoke from solid fuel use. A recent assessment concluded that the deaths o f as many as 444,000 children under five years old may be attributable to solid fuel use (Smith 2000, Smith and Mehta 2000). Another study estimated that child mortality i s about one-third lower in households using clean fuels than in comparable households using biomass (Hughes et a1 2000). Converting to clean fuels would eliminate this health risk. However, for the majority o f rural households, biomass will continue to be the main cooking fuel, largely due to its relatively low cost (World Bank 2003a). Therefore, there i s a need to find and promote cleaner ways o f using biomass. International experience has shown that highly successful programs typically include financial assistance for technical development, stove design, marketing and public awareness campaigns. The national government can contribute through program evaluation, provision o f training and seminars, and information sharing among programs. The dissemination o f information about health risks o f biomass fuel and mitigation options can lead to a greater willingness to switch to safer fuel or at least modify behavior and cooking areas. Community-based interventions are needed to assure that solutions are cost-effective, sustainable, and tailored to local conditions. 2.94 Withinthe health sector, combating communicable diseases should continue to be the highest priority for public funds. This i s due to: (a) clear, large externalities o f 9 - 8 - control, including true public goods such as 7 - swamp drainage and large scale vector 6 - (pest) control; (b) benefits that are heavily 5 - skewed to the poor. The differential o f 4 - 3 - incidence between rich and poor in 2 - communicable disease i s multiples o f that 1 - for non-communicable disease (Figure 2.9); o + , and (c) relative to medical care, most o f I I/ 111 IV v VI VI1 Vlll IX x these activities are much easier to Income Decile administer. Pulse polio campaigns, for example, only require professionals to be in +Tuberculosis x 10 +Malaria Blindness rural areas periodically without forcing source: world Bank, 1998 themto move their families. 2.95 The largest emerging problem in communicable disease control i s the increase ininfections o fthe Human Immuno-Deficiency Virus (HIV) and cases o f Acquired Immuno-Deficiency Syndrome (ADS). Estimates o f the spread o f the HIV infection, ranging from 4-8 million in 2002, are subject to much 57 DALYs measure years of life in a population lost to premature death and years lived with a disease or disability, adjusted for its severity. 42 dispute. But there i s no dispute that the infection i s spreading rapidly. Some predictions are that as many as 20 to 25 million cases will occur as soon as 2010 (a more than doubling of current, approximate, estimates o f prevalence). The HIV/AIDS crisis presents a unique challenge for leadership inIndia. There are many competing needs for the public health infrastructure, and it i s important to ensure that HIV/AIDS programs neither undercut resources to deal with other hllers like tuberculosis (TB), malaria, and diarrhea, nor get marginalized. 2.96 The main focus o f HIV/AIDS policy should be on prevention. Treatment i s expensive and has the possibility (as demonstrated inthe US, Europe and Australia) o f undermining prevention activities by mahng contracting the disease less o f a catastrophe. Instead, treatment should only be used if it can complement prevention efforts as, for example, as an inducement for testing. Surveillance o f the disease should not be limited to public ante-natal clinics and other standard locations. Much more attention i s needed for accurate measurement o f the incidence as well as researchto understand the sexual (and drug use) behavior o f people if effective prevention strategies are to be designed. Finally, while the political obstacles are severe, the epidemic can only begin to be controlled if there i s a candid public discussion o f sex. People must be able to know the extent o f their risk and how to reduce this risk with safe sex. Ifthis i s not done, the country faces a genuine disaster. Education Strategy and Policy Priorities 2.97 Progress in education has been much greater than in health. Enrollments have responded to higher expenditure, political support has been more reliable inmany states, and there are several notable success stories within India. Nevertheless, there are large variations across states and the current rate o f aggregate progress in education indicators i s insufficient to attain the goals in the Tenth Plan. Of 200 million children in the age group o f 6-14 years, 42 million do not attend schools. There are problems relating to high drop out rates, low levels o f leaming achievement, and low participation o f girls. Coupled with these are various systemic issues like large-scale teacher vacancies, high teacher absenteeism, and inadequate teaching- Table 2.12: Education Spending in India and Comparator Countries leaming materials. 2.98 India's overall Country GDP per capita Public expenditure per student (US$, 2001) (as % of GDP per capita) spending on education i s not much different than that Primary Secondary Tertiary of other countries at similar income levels (Table 2.12). India 460 7.2 23.1 92.5 Expenditure composition, Indonesia 690 3.2 8.7 12.2 however, i s somewhat Brazil 3070 12.5 12.6 72.8 more skewed towards the China 890 6.1 12.1 85.8 secondary level and Pakistan 420 n.a. n.a. n.a. considerably more skewed Malaysia 3330 11.2 19.9 86.1 towards higher education. Thailand 1940 12.5 12.8 38.2 Given the distinctive Mexico 5530 11.7 13.8 45.2 feature o f India, in which a Russian Federation 1750 n.a. 20.5 15.8 very sophisticated South Africa 2820 14 17.9 61.3 academic tradition coexists Source: World Development Indicators,2003; UNESCO Institute for Statistics with mass poverty, it i s perhaps not surprising that higher education i s expensive in terms o f GDP. This does not mean, however, that highereducationi s a highpriority use o f public money as opposedto private. 2.99 To accelerate progress inelementary education, the Government of India launchedin 2000/01 the Sarva Siksha Abhiyan (SSA, or Education for All) program. It aims at providing eight years o f schooling for children in the 6-14 age group by 2010. Go1has also enacted a Constitutional Amendment (93'd) that 43 makes free and compulsory education a fundamental right for children in the 6-14 years age group. Universalizing the completion o f primary schooling, and then elementary schooling, across all Indian states will require both additional public resources for these levels o f education and improvements inthe effectiveness with which public resources are used. The central issues are: 0 H o w to ensure that all children, particular poor children, become enrolled in primary school and are able and willing to complete an elementary education o freasonable quality? 0 What can be done to improve community-school relationships and to make the education system, including the teachers, more accountable to the communities they are intended to serve? 0 To what extent, and how, can the experiences o f educationally stronger states be replicated in weaker performing states to improve completion rates and levels o f learning achievement? 2.100 Education differs from health inthat it i s possible to rely on communities and parents to monitor and evaluate school performance to a much greater degree than i s possible with health-facilities. Parents are in the best position to monitor what goes on in schools. They may not know the best pedagogical techniques, but they do know whether or not the teacher comes to work. And even illiterate parents can tell if their children are learning anything. So, effective reform will almost certainly put more power into their hands. Inurban settings where there i s the possibility o f choice o f schools, increasing market power with vouchers (maybe for the poor, maybe for everyone with limitson topping up) mightbe experimented with, The essential feature is to allow money to follow the student. And to allow schools enough autonomy to be able to compete for it. 2.101 Inrural areas, where little or no real choice is practical, increasing parent voice and influence on school operations i s a good option. Making schools more accountable to the community i s critical, possibly as far as giving parents the right to hire and fire teachers in the context o f local school committees. The most promising developments in primary education have been in Madhya Pradesh, where communities have been allowed to hire informal, less qualified, teachers at much lower wages than possible in the civil service with much better performance in terms o f attendance as well as educational outcomes. Other states, such as Rajasthan and Uttar Pradesh have also experimented with para-teachers who, although with lower qualifications and earning a lower salary, appear to provide better services.58 States will differ in the degree and form in which they rely on parents and communities depending on their ability to monitor andensure goodperformance from their teachers. While parents inthe community schools in Madhya Pradesh can dismiss and hire teachers, other states might find that ordinary complaint procedures through panchayats can work as well. Inall cases, however, the active participation o f parents i s likely to be a major factor in all successful education reforms for a long time to come. 2.102 There may also be more scope for competition in education than is ordinarily considered. Competition can be for concessions to establish a school in a village even if there will be only one. Further, competition can be enhanced by makmg it easier for children to reach the competition. In Kerala, for example, substantial subsidies are given for transportation. Parents can shop around for better schools and the revenue o f the school depends on enrollments. 2.103 Schools need to be given enough autonomy to act on attracting teachers and students. Circumstances across India differ enormously and reaching the poorest and most remote children will require flexibility and experimentation. Once again, localities must be allowed the freedom to find their best solutions and higher levels o f government can help by establishing more regular measurement o f attendance, of learning outcomes and other information needed to evaluate progress. This helps individual districts adjust their strategies and allows other districts to learn. 58 For example, a recent evaluation of a remedial education program run by Pratham (an NGO) concluded: "Hiring remedial education teachers from the community appears to be 10 times more cost effective than hiringnew teachers". See Duflo (2003). 44 2.104 Experience i s buildingon making contracts with government contingent on better performance on tests, NGOs and possibly for-profit institutions can be given operating budgets contingent on independent measures of improvement inteaching. While over-reliance on test scores carries risks (such as "teaching to the test" and ignoring less quantifiable aspects o f education) many parents would be happy if enough teaching was taking place that test scores improved. One way or another, schools should be more accountable for better outcomes. This can be done in many ways - contracts with local governments, contracts with state departments of education, giving parents a greater say in school governance or a greater choice between schools where attracting students i s in the school's interest. The common feature i s separation between the funder o f the school and the provider, with the latter beholden to the former. 2.105 Above primary education, there i s substantial increased demand for upper primary and secondary education, partly as a result of the success in increasing primary enrollments. Inmany states, secondary schools are grant-in-aid institutions (private schools paid for by public funds) and there i s concern over the quality o f education insuch facilities. Inmany states, there are also concerns about leakages in grant- in-aid expenditures. Again, more regular evaluation o f outcomes can both improve oversight o f such contracts as well as increase public accountability o f the use o f public funds. Providing Effective Social Safety Nets 2.106 Anti-poverty programs, or social safety nets, suffer from the same lack o f focus on outcomes. The nature o f the poverty problem has changed dramatically since the establishment o f the major anti- poverty programs such as the Public Distribution System (PDS) in the early post-independence era. Then, mass poverty - at rates o f 60% or more - meant that universal programs were bound to help poor people. Now, with poverty rates below 30% and falling, there i s greater need to avoid waste o f public resources by making sure that program funds actually reach poor people. This, in turn, means more careful monitoring of programs to determine how much it costs to transfer a rupee to a poor person. 2.107 These costs vary widely among programs. One study compared five programs and found that it cost from 1.8 rupees for each rupee ultimately received by someone below the poverty line through the ICDS, a nutrition and pre-school education program, to over 6.3 rupees through the "two rupee per h l o " food distribution scheme of Andhra Pradesh." The PDS cost over 5.3 rupees per rupee transferred. Included were both administrative costs associated with determining eligibility and implementation as well as "leakage" costs o f benefits that reach people above the poverty line. Since many state programs are tied to PDS eligibility conditions, its inability to discriminate between poor and non-poor (there were fully 2.8 non-poor for eachpoorbeneficiary) is a matter of great concern. 2.108 One general rule that has emerged from comparison o f programs i s that self-targeted programs, such as the Maharashtra Employment Guarantee Scheme (GES), do tend to reach the poorest better than those that rely on administrative discretion for eligibility. Self-targeted programs allow people to choose to participate but are designed to attract the neediest. For example, if wages in a GES are below prevailing wages, only the neediest will volunteer. These programs are cheaper both in terms o f administration, since there i s no eligibility to check as well as in leakage, since only the poor will volunteer.60 The lesson, though, i s not that one existing program i s better or worse than another but that, once again, all programs should be continually re-examined in terms o f their effectiveness. Regular monitoring, measurement o f actual outcomes and re-focus o f programs i s essential. 59Radhakrishnaand Subbarao(1997). 6oRavallion and Datt (1995). 45 Towards the Future 2.109 Many internal and external observers o f Indian administration have argued that decentralization and local empowerment will ultimately be essential in improving the quality o f service delivery at the village level. Faced with slow and unevenprogress on decentralization, the 73rdand 74* Amendments to the Constitution, ratified in 1992, imposed on states the obligation to decentralize to lower levels. The Amendments created distinct rural and urban govemments, mandated periodic elections and the establishment o f an important accountability mechanism, the Gram Sabha (village assembly), but left other matters o f implementationto the states. The most visible achievement o f these reforms has been the high degree of political decentralization. With the election o f over three million local politicians, one thirdo fwhom are women and around20% from scheduled castes andtribals, India's decentralization has, at least nominally, opened the state to democratic participation. However, progress on fiscal and administrative aspects o f decentralization has been much more modest and hesitant. Administrative evolution has often failed to take account o f the limited capacity o f local governments, the existence o f economies o f scale for delivering services, or the potential role o f the private sector. And a serious overlap o f responsibilities between state, district, block and village governments obscures lines o f accountability to voters. For the most part, local governments still raise little revenues o f their own (although the potential i s much higher) and also deliver few services. Rather, they are usually treated by state and central bureaucracies as service agents for higherlevel governments. 2.110 India now needs to move from the decentralized patchwork it created towards an inter- governmental framework which leads to improved service delivery without increasing fiscal pressures. Good fiscal management would suggest reallocatingpublic funds from central and state schemes into a well-designed fiscal framework for local govemments, that would guarantee their autonomy and accountability, while helping them to match resource allocations with local preferences. It would also suggest creating incentives for local governments to collect a share o f their revenues from local taxpayers (e.g., through land taxes). Flows o f funds from the center and state governments should be dependent on good performance and resource mobilization at the local level. Performance should be monitored not only by the Local Audit Fund, but also by local joumalists, civil society groups and panchayat leaders from neighboring districts. This would help strengthen accountability, and ensure greater participation and empowerment o f local communities- one o f the primary objectives o f the decentralization process. 2.111 India's federal structure, common institutions and practices between states, and the ongoing program o f decentralization make it a fertile laboratory for reform. A variety o f changes are being implemented at the center, state and local levels, with varying degrees o f success, which can be quickly scaled up and disseminated across the country. India i s one o f the leaders in the information technology revolution, and states such as Andhra Pradesh and Karnataka are malung impressive gains in the application o f IT solutions to a variety o fpublic sector problems. For all o ftheir weaknesses, cadres such as the Indian Administrative Service remain a tremendous reservoir o f talent and capacity. Perhaps most important, a number of broader dynamics -- such as the rise o f the Indian middle class and the growth o f NGOs dedicated to issues o f good governance -- are fostering increasing social demand for good governance. Thus, while the nature o f the Indian public sector reform agenda has remained relatively fixed for a decade or more, India itselfi s changing inways that make its realization more feasible. 46 PART 111:POLICY AGENDA: IMPROVING THE INVESTMENT CLIMATE 3.1 There i s little doubt that India's economic performance has been aided by the structural reforms introducedover the past decade. However, it also seems clear that higher levels o f private investment and productivity will be needed to raise the growth rate to 8% per annum, as targeted in the Tenth Plan. Compared to many other countries in Asia, India's private sector faces a relatively unfavorable investment climate. This constrains productivity and employment creation in industry and services, and reduces India's ability to compete in world markets. Agricultural performance i s constrained by imbalances in public expenditure, which favor subsidies over productivity-enhancing investments, and remaining restrictions on trade and competition. Development o f the non-farm sector will be essential to provide employment opportunities inrural areas, and support the agriculture sector. 3.2 Part 111.1reviews recent progress inimproving the business climate for industry and services, and proposes an agenda o f policy reforms to encourage more investment and higher productivity in the coming years. Part 111.2 covers the same ground for agriculture andrural development. 111.1:INDUSTRYAND SERVICES the early 1990s (Box 3.1). The industrial sector grew by Figure3.1: Private Investmentin Industry 7.6% per annum, and and Services,(annual averagegrowth rates) manufacturing by 9.8% per 120 - annum, in real terms from 100 - 1992193 to 1996197 (Table 80 - 3.1). Private investment in e 6 0 - industry grew by 20.1% per annum in real terms over the 1 2o same period (Figure 3.1). However, the momentum slowed in the second half o f -40 - 1991192 1992193 1993194 1994195 1995196 1996197 1997198 1998199 1999100 2000101 the decade, with industrial --O-Privateinvestmentinindusty ,. D Privateinvestmentinsewices 1 growth averaging Only 4*5% per annum, manufacturing Notes: Private investmentde!mdas gross domestic fixed capitel formationin the private sector ~ource:Centa statistics Organization Table 3.1: GDP, Industry and Services Growth Rates" 1992193-1996197 1997198-2001102 2001102 2002103 GDP at factor cost 6.7 5.5 5.6 4.4 Industry 7.6 4.5 3.3 6.1 Mining and Quarrying 3.6 3.8 1.o 4.8 Manufacturing 9.8 3.8 3.4 6.1 Electricity, Gas &water etc 5.5 5.9 4.3 5.2 Construction 3.6 7.0 3.7 7.1 Services 7.5 8.1 6.8 7.1 Trade, hotels, Transport & communication 8.8 7.9 8.7 7.8 Trade, hotels & restaurant 9.1 7.1 8.8 n.a. Transport, storage &communication 8.1 9.6 8.5 n.a. Financing, insurance, real estate & business 8.0 7.5 4.5 6.5 services Community, social & personal services 5.1 9.1 5.6 6.4 Notes: "Compound annual growth rate % Source: Central StatisticalOrganization 48 3.4 Latest (provisional) estimates based on a redefinition o f foreign direct investment (FDI), in accordance with international best practices,52indicate that FDI in India stood at about 1.3% o f GDP in 2001/02, declining to 0.9% in 2002103, compared with 4% in China and between 2% and 3% in many emerging market countries. Unlike inChina and South East Asia, FDIinIndia has been oriented towards the domestic market and not towards exports. No significant increase in India's penetration o f world markets in industrial products has been observed over the past decade, with the share o f non-agricultural exports in world exports o f the same commodities having increased only marginally from 0.5% in 1990/91 to 0.55% in2000/01. Unlike its experience with trade in goods, India in a short span o ftime has achieved a prominent position in global trade in services, today accounting for 1.4% o f global exports in services. However, this growth has taken place on the back o f a narrow set o f sub-sectors, primarily software exports, which grew at an annual average rate o f 49% during the second half o f the 1990s. In contrast, India's performance in service segments such as travel and transportation services, where the underlying growth i s linked to trade ingoods, has beenmediocre. 3.5 The organized industryand services sectors today account for 27 millionjobs, o f whichjust seven millionjobs are in manufacturingand some 17 million are in the services sector (some 70% o f organized sector jobs are inpublic sector units). By comparison, the total labor force inIndia i s around 406 million, with a little under one million workers moving out o f agriculture every year. The organized services sector has generated some 760,000 new jobs over the past decade, while employment in organized manufacturinghas remainedalmost unchanged, with only 350,000 newjobs having been created between 1993/94 and 1999/00. Growth in total manufacturing employment (organized and unorganized) in India has averaged only about 2% per annum during the period 1994-2000, with the unorganized sector accounting for the bulk o f this 3.6 Over the past 12 months, industryhas begun to show signs o f recovery, fueled mainly by a better use o f existing capacity rather than by new investments, and by the lower interest rates that have resulted inhuge windfall gains for industry. Industrial growth for 2002/03 is estimated to be 6.1%, compared to 3.1% for the previous year. However, as emphasizedinthe Tenth Five-Year Plan, much higher industrial sector growth will be required to create the targeted 100 million or so new jobs over the next decade. This will need to be accompanied with an acceleration o f growth inlabor-intensive services such as retail trade. The Plan notes that sustained growth and employment will require a step up in domestic investment, particularly private investment, coupled with improvedproductivity. 52Inaccordancewith the new andexpandeddefinition ofFDIreleasedby Go1on July 2,2003, FDI is definedto include,besides equity capital (which comprises the equity capital o f unincorporated entities, now also including the equity capital o f foreign banks' branches in India, control premium and non-competitionfees), reinvested earnings of incorporatedand unincorporated entities and other capital (including short-termand long-termborrowing,trade and suppliers' credit of more than 180 days, and financial leasing). 53Basedon the NSS figures as reportedinthe Report ofthe Task Forceon EmploymentOpportunities,(Go12001a) 49 3.7 The investment climate varies considerably across the states. In general, there i s a clear link betweenthe investment climate and industrialperformance (Figure 3.2). Indeed, states such as Kamataka and Gujarat, which were rated as the better investment climate states by the CII-World Bank study (2002), recorded high industrial growth rates (in excess o f 8% during the Figure3.2. StatelevelIndustrialGrourth,byState, 199&99 1990s). Kamataka i s also by far (averagecompoundgrowthrateperannum,%) the leader (among the Indian states) inthe export o f IT services Kamataka and also receives the highest FDI. Rajasthan Kerala and West Bengal, which Gujarat were ranked among the poorer Havana investment climate states, UP Maharashba recorded much lower industrial Tamil Nadu growth during the 1990s. The Ap only real outlier was Uttar Madhya M e s h Pradesh, where, despite a rather Funjab poor investment climate, industry West Bengal grew at 6.4% per annum during Kerala the 1990s. However, it may be Crissa noted that UP'S industry grew Bhar from a very low base, and the O.W/o I.W/o 2.03% 3.03% 4.03% 6.00% 7.00%8.Wh 9.Wh growth during the latter part o f 5.00% Source: Staff Estimates k e d on CSOdata 1990s may be attributed largely to central government (rather than state-level) reforms, the impact o f which began to felt with a lag, during the second half o f the 1990s. Even the better investment climate states are still way behind the curve compared to India's South-East Asian and East Asian competitors. 3.8 International comparisons indicate that India has intrinsic advantages that should allow the country to emerge as a major hub for manufacturing and labor-intensive service industries. These advantages include relative macroeconomic stability (provided the fiscal issues noted above are addressed), a local market that i s among the largest in the world, a large and relatively low-cost labor force, a critical mass o f well-educated workers in the areas o f engineering and science, and abundant raw materials. But over five decades of protectionism, state-ownership and selective interventions, have created deep distortions, stifling India's private sector development, competitiveness and growth. It i s now widely accepted within India that the government would do far better by focusing on creating a conducive environment and level playing field for the private sector. More specifically, improving the performance o f India's industrial and services sectors would require tackling simultaneously three key sets o f issues to create a conducive investment climate: (a) removing product market distortions; (b) improving the efficiency o f factor markets; and (c) alleviating infrastructure bottlenecks. The success with which India can achieve the ambitious targets set inthe TenthPlanwill depend crucially on progress inthese areas. Investment Climate: Key Constraints andPolicyPriorities Product Market Distortions 3.9 Inadequate follow-through on the industrial policy reforms and slow progress with trade reforms that were initiated inthe early 1990shas ledto the persistence o f product market distortions that continue to inhibit industrial and services sector performance. There i s now broad agreement that further progress inthese areasisneeded. The key is to pushaheadwithimplementingreforms as quickly as possible. 50 3.10 A key area where industrialpolicy reforms needto move faster relates to India's policy of small scale industry (SSI) reservation. At the start o f the reformprogram o f the 199Os, about 800 items were reserved for exclusive production in the SSI sector, which meant that investment inplant and machinery in any individual SSI unit could not exceed a specified monetary ceiling. Over the years, this list has been only slightlypruned, so that, as o fJune 30, 2003, a total o f 674 items remainedreserved exclusively for the SSI sector, although non-SSI firms can now obtain a license to produce products reserved for the SSI sector, provided they are exported. Inthe case o f 610 o f these reserved categories, total investment in plant and machinery for any single firm i s capped at an upper limit o f Rs.10 million (a little over US$200,000), while for 64 reserved items, the investment cap has been raised to Rs.50 million (about US$1 million). This policy o f product reservation and investment ceilings has held back the SSI sector from achieving economies o f scale and greater efficiency, by inhibiting small firms from investing beyond the stipulated limits, expanding their operations in the domestic market, and then moving into exports. N o w i s the time to eliminate this policy o f SSIreservation, which would unleash the potential o f India's small-scale players, encouraging small businesses to grow and compete on world markets. 3.11 Trade policy. Import licensing has been abolished. While rapid progress was made in tariff reductionuntilthe mid-l990s, the process has slowed since then (Box 3.1), and highimport tariffs remain a key constraint to better industrial performance and competitiveness, driving up the prices o f manufactured products, suppressing demand and providing opportunities for inefficient firms to survive and for efficient firms to capture rents. Many tariffs, mostly on agricultural products and processed foods, but also on some industrialproducts (e.g., automobiles) are far above the new "peak" customs dutyrate of 25% introduced in the 2003/04 budget. In March 2003, including the protective effect o f the Special Additional Duty (SAD), the un-weighted average protective tariff was about 32.7%, overall, 30.7% for industrialgoods and 46.8% for agriculturalproducts including processed foods. This i s far lower than pre- reform tariff levels during the 1980s, but still very highby world standards. Infact, comparing the un- weighted average Customs duty rates o f 105 developing countries between 1996 and 2000, India's average tariff was the second highest (next to Morocco). Even without allowing for the SAD, India's current tariffs are much higher than average tariffs in other large developing countries: e.g., more than double China's and Brazil's, four times Indonesia's, and two and a half times the average o f developing countries (Table 3.2). Reducing import tariffs i s critical to improving industrial performance. The aim for India should be to reduce import tariffs on all imports to a single rate (say, 10%) over the next three to four years. This schedule would give domestic manufacturers the time to restructure and become competitive, and i s comparable with the rate o f tariff reduction in countries such as China and Brazil over the past decade (China's import duties are expectedto average 9% by 2005). 51 Box 3.1: Key Structural Reforms Since 1991 The structural reform program initiated in 1991 envisaged a decisive shift in industrial and trade policy, the policy towards private and foreign investment in industry and services, and financial sector policy. Over the years, major changes have been made insome o f these areas, but slow progresswith industrial and trade liberalizationremain matters o f serious concem. Industrialpolicy reforms.Follow-through on liberalizing industrial policy has been slow and inadequate. Some measures have been taken since the early 1990s: central govemment industrial controls were mostly dismantled in the early 1990s; the earlier reservation o f eighteen industries for the public sector, which prevented the private sector from investing in these areas, has been reduced to three (defense aircrafts and warships, atomic energy generation and railway transport); central govemment industrial licensing has been almost completely abolished except for a few hazardous and environmentally sensitive industries (although a pervasive regime o f govemment inspection and clearances remains); the requirement that investmentsby large industrial houses be cleared separately under the Monopolies and Restrictive Trade Practices Act (MRTP) to discourage the concentration of economic power has been abolished and the MRTP Act has been replaced by a competition law which will attempt to regulate anti-competitive behavior. These reforms notwithstanding, three key areas that need immediate attention include removing small- scale industry reservation, reducing govemment interferencehureaucratic hassles related to the entry and operation o f firms, and improving the bankruptcy framework to faditate the exit o ftroubled firms. Trade policy reforms have also been gradual. Import licensing for most capital and intermediate goods was abolished in 1991. However, import licensing for manufactured consumer goods and agricultural products (for most products, a defacto import ban) remained in place until it was removed in stages between 1997 and 2001, following pressures from the US, EU and other developed countries under the WTO dispute settlement mechanism. Un-weighted average tariffs declined sharply from 128% in 1990191 to 34.4% in 1997198. But the trend was reversed in 1998199 when, on average, tariffs increased by about 5 percentage points, and remained above the 1997198 levels until a new reduction program commenced in 2002103. The increase during I998/99-2001/02 was due to protective import taxes on top o f customs duties, initially a "special duty", then a "surcharge" (both now abolished), and finally the present Special Additional Duty (or SAD). Industrial tariffs were reduced again in the 2003104 budget, but agricultural tariffs have been omitted from the reduction program and are now much higher than non-agricultural tariffs. India used the Uruguayround negotiations to support its program to reduce industrial tariffs during the 199Os, but about a third o fits industrialtariffs remainunbound andmost ofthe rest are bound at a highrate by intemational standards (40%). With a few exceptions, agricultural tariffs are bound very high and, inmost cases, at prohibitive rates of loo%, 150% or 300%. Policiestowards private sector participationand competition. Over the past decade, Indiahas made considerable advances in reducing the state's role in key industry and service sectors, and opening these up to domestic and foreign competition. Public sector units in sectors such as aluminium, car1auto manufacturing, telecommunication and IThave been privatized. Insectors like telecommunications, banking, insurance, and health, which were previously under the exclusive control o f public sector monopolies, private companies, both domestic and foreign, have been allowed to operate. Foreign direct investment (FDI) policies were substantially liberalized at an early stage o f the reforms and the process was extended further at regular intervals, Limits on the share o f foreign equity allowed have been liberalized by allowing 100% foreign ownership in a large number of notifymg lists o f industries that are eligible for automatic approval up to the specified levels o f foreign equity (loo%, 74% and industries and majority ownership in almost all the others. Procedures for obtaining permission were also greatly simplified by 51%) and requiring potential investors only to register with the Reserve Bank o f India. Inaddition to liberalizing FDI, qualified institutional investors were allowed in 1993 to invest in Indiancompanies by purchasing shares in the stock market subject to a maximum percentage and this percentage has been progressively liberalized. Financial sector reform. Reforms in banking have included dismantling the complex system of interest rate controls, introducing prudential norms and capital adequacy requirements in line with intemational standards, strengthening banking supervision, creating a more competitive environment in banking by more liberal licensing o f private banks and expansion by foreign banks, strengthening the framework for bad debt recovery through the enactment o f the Securitization, Reconstruction o f Financial Assets and Enforcement o f Security Interest Act (2002), and improving the bankruptcy framework through Amendments to the Companies Act (2002). A number o f reforms have also been introduced to strengthen stock market regulation. Nevertheless, concems remain about the intemitv o f the markets. 52 Table 3.2: Un-weighted Average Customs Duty Rates in India and other Developing Countries All goods Agriculture Manufacturing India 2001102(CD only) 32.3 41.7 30.8 India 2002103(CD only) 29 40.6 27.4 India 2002103 (CDcSAD: estimate) 35 47.1 33.3 India 2003104(CDcSAD: estimate) 32.7 46.8 30.7 Pakistan 2001102 20.4 21.8 20.2 Pakistan 2002103 (estimate) 18.2 13.9 18.3 Brazil 2000 14.1 12.9 14.3 China 2000 16.3 16.5 16.2 Indonesia 2000 8.4 6.3 8.9 Thailand 2000 16.6 39.9 14.6 South Korea 2000 12.7 47.9 6.6 105 developing countries (1996-2000) 13.4 17.4 12.7 Notes: CD=CustomsDuty; SAD=SpecialAdditional Duty. The India2001102 tariffs are Customsduties from the WTO TPR report, Jan 2002.They do not includethe SAD. The India 2002103 and 2003104 averagesare from Arun Goyal, EasyReference Customs Tarif2003/4, plus additional informationsupplied by the author. The protectiveeffectof the SADwas estimatedfrom the average Customs duty by assuming an average 16% additionalduty rate.The 2001102 averagetariffs for Pakistanare from the January 2002 WTO TPR reporton Pakistan.The 2002103 averagetariffs for Pakistanare estimatedfrom the 2001102 averages by assuming that all 30% tariffswere reducedto 25% followingthe cut in the general maximum rate from 30% to 25% in the 2002103 budget. There are no other explicitlyprotective import taxes than Customs duties in Pakistan.The averagetariffs for other developing countrieswere compiledby Francis Ng (DECRG-TR)from WTO, IDB CD ROM2000 and Trade Policy Review,various issues, 1993-2001; World Bank. Source: SouthAsian Trade Policies:An Overview - ZaidiSattar and Gary Pursell, Draft Report,April 2003 3.12 Furthermore, various tariff exemptions that increase effective protection to value added, create other distortions, and complicate tax administration, should be eliminated, preferably by bringing down the general level o f tariffs and reducing the demand for special treatment. A "Jumbo Exemption'' notification was introduced in 1996 to consolidate and bring greater clarity to the previous impenetrable maze o f exemption notifications, but since then the jumbo has grown and the total number exemptions now appears to be about double the number in 1996. In 2002/03 the Jumbo Exemption Customs notification listed 415 items for which some lundo f exemption i s allowed, each item corresponding to an HScode (two digit, four digit, or six digit) andmany supplementedby one or more o f43 detailed product lists which contain over 1,100 detailed product descriptions. The vast majority of these exemptions are for intermediate material inputs or for machinery and equipment items including spare parts, and may involve one, two or all three o f the basic customs duty, the additional (domestic VAT) duty, and the S A D . Other complications are createdby exemptions and partial exemptions which give excise tax advantage to small Indian firms over larger Indian firms, and also help the small firms in competing with imports which pay the equivalent of the normal domestic excise taxes, mostly 16%. Although the benefit to small firms has been reduced by the introduction o f VAT principles, the small firm exemption increases tax evasion opportunities and tax administration costs. 3.13 In addition, there is a need to recognize and deal with other forms o f protection which are undermining other efforts to liberalize the trade regime. The most serious o f these i s Anti-Dumping(AD). Starting in 1993, anti-dumping has become a major activity in India with over 300 cases completed, nearly all o f which have resulted inthe imposition o f specific duties on imports from particular firms and countries, which are added on top of normal import duties. The ad-valorem equivalents of the AD duties range from around 10% of normal international prices to over 100% o f internationalprices, with the total 53 resultingimport tariffs often prohibitive. The effects o f AD go beyond the products actually subject to AD duties, since the threat o f bringing AD actions can be used by domestic firms to prevent or limit competition from imports. India's AD activity (especially following recent anti-dumping duties imposed on imports from firms in Nepal and Bangladesh) i s influencing the other South Asian countries to also embark on anti-dumping and among other things i s complicating efforts to reduce barriers to regional trade. 3.14 As well as by anti-dumping, a number of other methods are also being used to provide extra protection. These include: (a) specific tariffs, used mostly to protect textile fabric and garment producers against low priced import competition, the ad valorem equivalents o f which (based on export prices from China and Korea) can be prohibitively high, ranging from 50% to over 100%; (b) the use o f govemment mandated import monopolies (State Trading Enterprises) to control imports o f foodgrains and fertilizers; (c) the application o f the MW (Maximum Retail Price) rules to imported consumer goods which raises the effective CENVAT (1.e. excise tax) rate as a proportion o f the cif prices o f some imports, above the equivalent rate on domestically produced products; (d) the application o f sanitary and phytosanitary (SPS) rules and technical regulations in ways which discriminate against imports; and (e) in February 2003, a new Customs Ordinance, one purpose o f which i s to give discretionary power to the Ministry o f Finance to act quickly to increase customs duties without obtaining the parliamentary clearance that was previously required. 3.15 The govemment has been making strenuous efforts to streamline and simplify its export policies, especially the large number o f schemes which are used to exempt, offset or refund import duties on imported inputs used by exporter^.'^ However, many long-standing problems in the administration o f these schemes have continued, including delays and highnegotiation and transactions costs for exporters. The basic underlying reason for these difficulties is the still very highlevels o f tariffs and indirect taxes which mean that fast and complete rebates or exemptions are essential for profitable exporting, but which on the other hand create large potential economic rents from the misuse o f the schemes, which in tum lead to large numbers o f different schemes to meet different circumstances and to complex layers o f control. The difficulty this creates for exporters i s another major reason to substantially reduce the level o fprotective tariffs and to simplify their structure. 3.16 India has many well justified concerns about the policies o f other countries which restrict its exports o f goods and services where it has a clear comparative advantage, and it i s one o f the most active o f the developing countries in combating these policies in various international fora, especially at the WTO. O f particular concern are agricultural protectionisminthe EU, U S and other developed countries, escalated tariff structures in developed countries, the multi-fiber arrangement which restricts textile and garments exports, developed country regional preferential policies such as NAFTA which have diverted imports from India and other excluded suppliers, the misuse o f anti-dumping, sanitary and phytosanitary regulations, technical regulations as protective instruments, and the reluctance o f developed countries to allow Indians and people from other developing countries to provide services by temporarily moving withintheir borders. 3.17 However, this negotiating stance inrelation to developed country restrictions has been combined with defensive positions with respect to India's own commitments, as indicated, for example, by mostly prohibitively high agricultural tariff bindings, many unbound industrial tariffs, and conservative bindings under the GATS. Because of the size o f its economy, and even more its potential future size, India has some bargaining leverage in offering to trade some o fthese restrictions for concessions by other countries (Mattoo and Subramanian 2003). But these potential future economic benefits should be weighed against the current and ongoing economic costs o f not taking advantage o f the opportunity offered by the WTO process to help tie in liberalizing reforms by making them more difficult to reverse under the pressure of 54 Current export policies are outlined in the Ministry of Commerce Report ofthe High Level Committeefor the Exim Policy, 2002-07, (GoI, 2002a). 54 domestic protectionist forces. The WTO bargaining process can also help overcome domestic interests resistingtrade liberalizationby balancingincreased import competition inthe domestic market with better and more secure access to export markets. From this perspective, some o f the recent directions o f Indian trade policies, especially the routine use o f anti-dumping, the use o f SPS and technical regulations for protection purposes, and the subsidized exports o f rice and wheat, are emulating developed country practices about which India rightly complains, and are likely to undermine its credibility innegotiating for multilateralrules to limit their future use. 3.18 Domestic taxes. The business environment in India has greatly benefited from the introduction o f VAT principles and the gradual broadening and simplification o f the previously extremely complex central government indirect (excise) tax system, now known as CENVAT. This has been under way since the mid-1980s and has continued with major improvements in recent years (especially as regards the textile sector), despite a recent move to a basic three-tier structure (8%, 16% and 24%) rather than a system with a single basic rate. But in sharp contrast to an overwhelming majority o f developing countries (by 1998, 116 countries around the world had adopted VAT or a VAT-like tax), India has not yet introduced a VAT. It has been announced that sales taxes will be replaced by a VAT regime, originally expected to be introduced on April 1, 2003. But VAT implementation has been delayed. If fully and uniformly implemented across all states, the VAT should help eliminate distortions caused by the cascadingeffect of sales taxes applied at each stage o fthe value chain. 3.19 In the meanwhile, however, the prevailing indirect tax regime in India creates significant distortions and transactions costs, and the indirect tax rates remain quite highrelative to other developing countries (Table 3.2). A recent calculation (CIVMcKinsey 2002) suggests that a lowering o f domestic sales taxes inIndia would significantly reduce costs inthe value chain, lower consumer prices, and result inrapid growth in domestic sales volumes, without having an adverse impact on government revenues (given the elasticity o f demand for manufactured goods and also given that reduction in rates would encourage firms to move from the unorganized to the organized sector, thereby bringingthem into the tax net). Another tax-related distortion worth mentioning relates to the granting o f discretionary tax holidays by various states in India. While this problem has been reduced since the abolition o f sales tax concessions post-1999, it does continue to create a fragmentation o fmanufacturingcapacities, resulting in highcosts. 3.20 While FDI policies have been significantly liberalized, FDI i s still allowed only in selected sectors (e.g., telecom, insurance, etc.) and i s still subject to limits, particularly on full ownership by foreign players. For example, FDI i s not currently permitted in pure retailing (global retailers can only participate in India's retail sector through wholesale trade or by operating retail outlets through local franchises). In apparel, which i s another important sector from the viewpoint o f job creation, FDI i s limitedto 24% o f equity. Inhousing construction, restrictions on foreign ownership o f land limit the entry o f foreign builders and developers into the construction market, so that foreign players face higher risks when operating in India as they are unable to take land ownership as collateral for the capital they have invested. Phasing out these FDIlimits would not only bring inthe necessary capital into these sectors (as the local capital markets and the pockets o f the Indian players are not deep enough to provide the necessary equity commitment) and generate growth and employment, but also, as shown by several studies, the entry o f multinationals would likely lead to technology and slulls transfers to domestic firms. Ifforeign firms introducenewproducts andprocesses, domestic firms would benefit from the accelerated diffusion o f technology. Diffusion could also occur from labor tumover as domestic employees move from foreign firms (which typically focus more onjob training programs) to domestic firms. 55 3.21 While the "License Raj" has been substantiallyreduced at the center, it still survives at the state level, along with a pervasive "Inspector Raj".55 Private investors require a large number o f permissions (e.g., electricity and water supply connections, environmental Table 3.3 Indirect Tax Rates in Selected Developing Countries" clearance, etc.) from state governments to start a business and ( 9/01 they also have to interact with the Standard rate Significant other VAT ratesu state bureaucracy inthe course o f day- to-day operations because o f laws governing pollution, sanitation, Asia workers welfare and safety, et^.^^ China 17 Starting a business in India requires India 8, 16, 24 10 permits compared to 6 in China, Indonesia 10 5, 20, 35 and the median time i s 90 days in Korea 10 2, 3.5 India relative to 30 in China, 10 according the World Bank's Doing Pakistan Business Database (2002). Philippines 10 Complaints o f delays, corruption and Singaore 3 harassment in these interactions are Sri Lanka 12.5 common. The World Bank's World Thailand 10 Business Environment Survey (2000) Africa found that managers in India spend Kenya 16 12 16% o f their time dealing with Mauritius 10 bureaucracy, compared to 9% in China, 11% in Latin America, and South Africa 14 12% in transitional Europe. The LatinAmerica opportunity cost o f managers' time i s Chile 18 considerable. The persistence of Mexico 15 10 controls also opens the door to Notes: 'With the exception of India,all of the countriesin the table have introducedVAT (or a possibilities for corruption. The same VAT-like)tax survey found that the share o f firms ZExcludesthe zero-rate on exports. While such multipleVAT rates are likely to complicate VAT administration, they are politicallyattractiveby ostensiblyserving-though not necessarily malung irregular payments in India i s effectively-an equityobjective.In fact, mostOECD countries have multipleVAT rates.Still, the about 90%, almost double that in administrativeprice for addressing equity concerns through multiple VAT rates is likely higher in Malaysia. To reduce the costs of developing, than in developed countries. Source: Tax Policies for Emerging Markets, Vito Tanzi and HowellZee, IMFWorking PaperNo. investment related to delays and rent 00135,Washington DC, March 2000. seeking, all procedures for entry of firms need t o be simplified and expedited. This requires re-engineering the entire gamut o f regulatory processes, especially at the state and local levels, on the basis o f clear principles o f transparency, absence o f discretion, and accountability. Introducing"single window" clearances would help greatly. Factor Market Distortions 3.22 Inefficiencies in factor markets, i.e., the markets for labor, capital and land, coupled with a weak bankruptcy framework, have further constrained the business environment. There i s less agreement on the way forward inthese areas, and strongpoliticalandvested interests against change. 3.23 Labor market restrictions on the hiringand firing o f workers are identified as one o f the greatest challenges o f doing business in India according to the Global Competitiveness Report - India ranks 731d 55 Itmay be noted that the License Raj still exists in some traditional areas, notably tariff and other protectionpolicies, and the rebateandtariff exemptionschemes for exporters. 56The recent Go1report on "Reforming Investment Approval & ImplementationProcedures" (2002) provides a good review o f some of the existingproceduralcomplexitieswith public andprivateinvestment. 56 out o f 75 countries (China ranks 23rd). Employment inIndia's registered firms (those with more than 100 employees) i s highly protected. Any registered firm wishing to retrench labor can only do so with the permission o f the state government which i s rarely granted. These provisions make labor rationalization very difficult, discourage the hiringo f labor inthe organized sector, and are especially onerous for labor- intensive sectors. They are obviously especially burdensome for exporters who have to compete with producers in other exporting countries. And they also explain the tendency o f FDI to focus on the domestic market rather than use India as a base for exports. A World Bank-CII Survey (2002) found that the typical Indian firm reported having 17% more workers than it desired and that the labor laws and regulations were the main reason why it could not adjust to the preferred level. The government has recently announced its intention to raise the limit for seeking permission from 100 to 300 workers. However, to become effective, this requires enactment o f legislative changes by Parliament (repealing Section 5B o f the Industrial Disputes Act), and the political sensitivity o f such changes are likely to make them very difficult to implement. While contract labor i s not subject to these retrenchment laws, the flexibility to hire contract workers i s limited by the Contract Labor Act which allows the use o f contract labor only for activities o f a temporary nature. Amendments to the Contract Labor Act, currently being considered by GoI, would allow the use o f contract labor for all activities - not just for activities o f a temporary nature. 3.24 Various expert committees appointed by Go1 and the Reserve Bank o f India (RBI) have emphasized that the lack o f adequate, timely financing on competitive terms acts as the single most important constraint to SME growth and de~elopment.~~Credit volume to small-scale units has declined since 1997, with the shrinkage o f the non-bank financial sector.58Small players in India typically cannot access any financing for start-up from commercial sources. Even after they have reached a break-even point in their operations, profitable small businesses face shortages o f worhng capital, investment funds and other types o f financing, that undermine their ability to grow. Interest rate caps on small loans lead to a rationing o f the supply of credit fi-om formal financial institutions, so that even the better performing SMEs are often forced to resort to informal sources o f finance, resulting in interest rates that are significantly above the prime lending rate (PLR). High interest costs o f Indian small businesses affect their international competitiveness; the World Bank-CII Survey found that interest costs over sales were a quarter higher for Indian firms than firms inSouth East Asia. 3.25 Inlarge part, the problemof SME financingmaybe attributed to market inefficiency.Transaction costs related to SME lending are highas most banks use the same lending technologies for small business financing as they do for large corporations, but they do not have the necessary credit information on SMEs to assess credit risk. Also, lenders' perception o f the default risk associated with lending to small business i s high, as these firms often lack collateral that would secure loans. Problems in using land as collateral (lack o f updated landproperty records and the uncertainty surrounding ownership), the non- recognition by lenders o f other types o f collateral, difficulty in collateral enforcement and loan recovery, and a bankruptcy framework that does not allow for the easy exit o f troubled firms, further dnve up the risko fdefault. 3.26 To improve the efficiency o f financial markets for SMEs, Go1needs to remove interest rate caps on small loans; facilitate the establishment o f well-functioning credit information bureaudcredit rating agencies for small borrowers; introduce legislative changes in mortgage registration to make the process more customer friendly; update land and property records for small loans; simplify the legal framework ''See,for example, theReport of the Abid Hussain Committee on Small Enterprises (1997), the Interim Report of the SP Gupta Study Group on Development of Small Enterprises (2000), and the Report of the SL Kapur High Level Credit Committee on SMEs (1998). 58Public sector banks' lendingto small scale firms has declinedfrom 2.5% of GDP in 1997198 to 2.2% in 2001/02,with total lending rising only 30% over the period. However, private banks' lending to the sector has grown 50% over the period, and foreign banks' lendinghas more thandoubled(froma small base), perhapsreflectingtheir ability to evaluateborrowersand earn reasonable retums inthe sector. 57 for collateral enforcemendloan recovery by introducing alternate, out o f court, methods o f dispute resolution between creditors and debtors (the recently enacted Law on Securitization, Reconstruction o f Financial Assets and Enforcement o f Security Interest, which allows for the out o f court settlement o f bad loans, should be extended to small loans); promote collateral substitutes, as well as the use o f peer group security in providing and pricing loans to SMEs; and strengthen the bankruptcy framework to facilitate the easy exit o f small firms, given their relatively high mortality rate. At the same time, banks should make efforts to introduce new technologies (e.g., credit scoring) for SME credit and also to train and motivate branchmanagers to provide loans to commercially viable SMEs. 3.27 Problems with the use and transfer o f land also critically affect the performance o f larger firms. Indeed, some 90% o f land parcels in India are reportedly subject to disputes over ownership, which take decades to settle in court. Furthermore, obsolete tenancy and rent control laws keep a large part o f urban real estate o f f the market. The freezing o frents at unrealistically low levels inMumbai, for instance, has raised rents for new properties to phenomenal levels while keeping rents for old but desirable properties very low. Practices such as this hamper the growth o f domestic retail trade and the construction sector by making it very difficult for new players to enter. A report on "India's Growth Imperative" by the McKinsey Global Institute (2001) argues that land market distortions account for about 1.3% o f lost growth per year. The central government has already abolished the Urban Land Ceiling Act which made changes in land use very difficult; however, only a few states have repealed their corresponding Urban Land Ceiling Acts, and this should be extended to all states. 3.28 Outdated bankruptcy proceduresand ineffective laws have, in the past, led to inefficiencies in - . - the system, making industrial restructuring almost impossible. Figure 3.3. Bankruptcies as a Share of Total Firms Recent estimates show that it i s entirely common for proceedings to Percent take more than two years, and over 4 1 60% o f liquidation cases before the HighCourts have beeninprocess for more than 10years. Not surprisingly, when loolung at the share o f firms that go bankrupt, India has a much lower share (0.04%) than other emerging markets, such as Thailand (Figure 3.3). USA Hungary France Czeoh Turkey Chile Thailand India Republic 3.29 The recently enacted Amendments to the Companies Act Source: World Bank-CII (2002) (in2002) should help improvethe bankruptcy framework. The Amendment stipulates the abolition ofthe Bureau o f Industrial and Financial Restructuring (BIFR), and the creation o f a new umbrella body -- the National Company Law Tribunal (NCLT) -- that will henceforth perform the tasks o f restructuring, amalgamating and winding up companies (tasks hitherto performed by the highcourts and district courts), and the revivalhehabilitation o f sick companies (a task hitherto assigned to BIFR). Under the new framework, courts will no longer have any powers inrespect o f mergers and liquidationlwinding up, and this should help expedite the process o frestructuringAiquidatingsick companies. However, repeal of the Sick Industries Companies Act i s essential for this new bankruptcy framework to become effective. The effectiveness o f the new framework will also depend to some extent on the pace o f labor market reforms, since the successful winding up o f companies may be hamperedby problems inretrenching workers. The recently passed law on the enforcement o f creditors' rights should help the process o f industrial restructuring, unlockmg the resources tied up innon-performing enterprises for more productive use, but to help the restructuring o f small firms, the law needs to be extended to cover the small scale sector. 58 Infrastructure Bottlenecks 3.30 Severe shortfalls in capacity, poor quality and high costs o f key infrastructure continue to constrain Indianbusines~es.~~ The most importantand difficult area is power sector reform. 3.31 Access to reliable power at reasonable costs i s a prime concern for most Indian businesses. Industrysurveys have found that acute power shortfalls, unscheduled power cuts (i.e., unreliable supply), the erratic quality o fpower supply (low voltage coupled with fluctuations), delays and informal payments required to obtain new connections, and very high industrial energy costs, present major constraints to Indian industry, with serious implications for overall industry performance and competitiveness. India- wide, the shortfall in 2001/02 was estimated at 7.5% for energy and 13% for peak demand, with substantial variation across states in the availability and reliability o f supply. Firms in Karnataka are reported to face, on average, daily power cuts o f 2.4 hours, compared to 6.6 hours (mostly unscheduled cuts) faced by their counterparts inHaryana (TEN, 2000). 3.32 Unscheduled power cuts impose substantial costs on firms. Average industrial production losses per unit outage are reported at Rs.5 and Rs.22 for firms in Karnataka and Haryana, respectively (TEN, 2000).60 Production losses due to outages are estimated at about 7.6% and 7.9% o f the production costs for hightension (larger firms) and low tension (smaller firms) industries, respectively, in Haryana, and a higher proportion o f 12.4% and 15.3% inthe case o f Karnataka. Some 40% o f the industries surveyed in Andhra Pradesh report damage to equipment due to the poor quality o f power and the damage i s much more costly for industries with sensitive equipment, and where process and quality i s heavily dependent on motor speed. 3.33 Not only does industry receive irregular and low quality power, but also, it i s charged tariffs much above the cost o f supply. Much o f this i s due to cross-subsidization o f power tariffs by state governments and widespread power theft that i s euphemistically referred to as "transmission and distribution losses". Inmost states, political factors have dictated that agricultural consumers pay little or nothing for the power that they consume, and households, too, pay relatively little and, often connive with the electricity departments to draw much more power than what i s billed. Industry ends up paying an average tariff o f Rs.3.81kWh (as against an average tariff o f Rs.2.39ikW for all categories) and an average cost o fpublicpower supply o f Rs.3.50kwh. Industrialtariffs for hightension industries inIndia are between 8-9 centskWh, among the highest inthe world, as compared to 8 cents in Argentina, 7 cents inBolivia, 6 cents inBrazilandThailand, and 3-4 cents inChina. Typical rates inWestern Europe are in the range o f 6-7 centslkwh. 59 This section focuses on infrastructure bottlenecks that are in most critical need o f being addressed in order to improve the business environment. One sector that i s not covered i s telecommunications, mainly because considerable progress has been made with reforms and most business surveys report that Indian firms are reasonably satisfied with the country's telecommunications infrastructure. The challenge now is to improve rural telephone-density and further improve overall access rates to communication services. 6o The wide difference between the two states is because the average production cost for industries is higher in Kamataka compared to Haryana, and firms in Haryanarely more heavily on self-generation. 59 3.34 The paucity, unreliability and poor quality o f power from the public grids has forced a greater proportion o f Indian firms to operate their own (captive) generators, further increasing the cost o f power faced by industry, and reducing firm-level competitiveness. The share o f fuel costs in the overall production costs o f Indian firms inall the major industrial sectors was higher in2000/01 than in 1994/95 (Figure 3.4). Captive power generation capacity is at present estimated at about 22,000 MWs, accounting for one-fifth o f the total capacity o f the power utilities. Some 69% o f the manufacturing firms surveyed across India by the World Bank-CII study had their own power generator, compared to 30% in China.61 Comparing garments and electronics with East Asian countries, energy costs in Indian firms were found to be double those in Indonesia, the Philippines and Thailand (Figure 3.5). While large firms can bear such costs, small and medium sized firms suffer severely. They either have to go without power, or else, install their own generator: the typical Indian SME has its own generator, tying up one-sixth o f its capital. This stunts the growth o fthe SME sector. Figure 3.4: Cost of Power Share of Fuel in cost of production (%) 100.00 , Growth in Captive Generation in Industries Metals & Metal Products 80.00 - Cement Fertilizers 60.00 - Chemicals 8 Plastics 40.00 - Textiles Tea 20.00 Food 8 Beverage 0 5 10 15 20 25 30 35 1070.71 1814.75 1976-73 1382-83 1986-81 1390-31 1934.95 1938.11 0 1 9 9 4 - 9 5 .ZOO041 Source: CMlE Energy, April 2002 Source: Taru, 2002 F i g u r e 3.5. E n e r g y Costs as Share of Total Sales Garments Electronics India China Indonesia Philippines Thailand ISource World Bank-Cll (20021 3.35 Power sector reforms are now widely accepted as fundamental to improving business performance. An urgent priority i s the need to rationalize power tariffs, depoliticize the tariff-setting process, and implement a phased reduction in cross subsidies that operate against industrial consumers. Several states have taken steps to depoliticize the tariff fixing process by establishing statutory regulatory 61 It may be noted that, instates that have made more progress with power sector reforms (e.g., Maharashtra) a smaller proportion o f firms (45%) had captive generators. In contrast, over 85% o f firms surveyed in Delhi and Punjab, and over 97% o f firms surveyed inWest Bengal, reported having captive generators. 60 authorities, and others should follow suit. Also, states such as Andhra Pradesh and Kamataka have introduced price incentive schemes to encourage industry to shift to the grid; initial results for Andhra Pradesh are encouraging with about 22% increase in demand during 2003, in response to the price incentives. Time-of-day tariffs need to be introduced for industries with peak and off-peak rates. To minimize the impact o f financial losses to the power utilities, cost recovery needs to be enhanced through tariffs charged to agriculture and residential consumers. Tariff rationalizationshould be accompanied by reforms to improve the reliability and quality o fpower supply through dedicated feeders for industries. 3.36 The above measures must be accompanied by steps to encourage greater private investment inthe power sector, hitherto constrained by the poor credibility and financial viability o f the sector. Key reform measures required include improvements inthe financial and operational performance o f the SEBs, and in distributional efficiency through commercialization and privatization. The strategy for privatizing distribution should consider focusing on privatizing the relatively commercially viable segments o f the network and, inparallel, developing altemate strategies for improving services and targeting subsidies in rural areas. Targeting a broader range o f potential investors and actively mitigating the perceivedpolicy and regulatory risks will be key to the successful privatization o f the distribution business. Trading by industries with self generation, along with other power suppliers, should be encouraged by providing open access to the transmission and distribution networks in a phased manner along with the elimination of cross subsidies duringan agreed time frame. 3.37 Since power sector reform i s primarily the responsibility o f the states, alleviating bottlenecks in this sector requires the full commitment o f state govemments. The central govemment can play a supportive role by introducing legislation to foster reforms to encourage private sector involvement. In this context, the newly passed Electricity Act 2003 should play a positive facilitating role, through for example, its provisions for moving to open access, the removal o f entry barriers for new generation, delicensing o f off-grid supply inrural areas, trading for distribution licenses, antitheft, and deepening of regulatory reforms. The new legislation effectively empowers Indian states to accelerate power sector reforms in the direction o f greater competition, better governance and private sector investment. However many implementation details remain to be decided, and the Act's ultimate success will depend on action at the state level. As noted inPart 11.1, the central govemment has also introduces a scheme for providing financial assistance to states willing to adopt a program o f reforms in the power sector. More critical, however, are likely to be continuing Go1 efforts to maintain a hard budget constraint for state- level utilities, including through rigorous policies on payments to central generation and transmission utilities. 3.38 Ensuringspeedy, reliable, door-to-door transport services is also critical to improving industrial performance. India has one o f the most extensive transport systems in the world. But the sector suffers from severe capacity and quality constraints. While notable progress has been made with the implementation o f the National Highways Development Project, India currently has no interstate expressways linkmgthe major economic centers, and only 3,000 k m s o f four-lane highways, compared to China, which has built 25,000 kms o f four to six lane, access-controlled, expressways over the last 10 years. Poor riding quality and congestion result in truck and bus speeds on Indian highways that average 30-40 km per hour, about half the expected averages. Go1 and some states are implementing major highway upgrading programs, with the 4-laning o f 13,000 kmnational highways being the most notable. In addition, the Tenth Plan proposes a number of road upgrading projects totaling 10,000 km, and recognizes the need to start investing soon in a program o f access controlled expressways to provide faster and safer transport in high-volume corridors. Meeting the Tenth Plan targets will require a significant increase in funding from the private sector, which has hitherto been limited. Although private financing o f transport infrastructure has increased considerably in recent years, it can realistically be expected to fund only a small fraction o f sector investment. In the short to medium term, much can be gained through greater efforts to strengthen the policy, regulatory and legal framework, so as to reduce uncertainties arising from political interference and weak contract enforcement, which have inhibited 61 private sector participation and investment in roads. Better cost recovery from users would also help; while India has made progress inroad user charges with the introduction o f a national fuel "cess" (tax) in 1999, resource mobilization through such charges remains low. Equally, reform efforts should focus on strengthening the road agenciedstate public works departments, to improve the financial performance and accountability o f these public sector agencies. And users and other stakeholders must be given a strong voice inoverseeing the planning and implementationo f transport infrastructure. 3.39 India's high-density rail corridors, too, face severe capacity constraints, compounded by poor maintenance and rolling stock failure; average rail speed i s only 24 kmper hour. As inthe roads sector, capacity expansion i s an urgent priority for railways, and must be accompanied by efforts to improve efficiency inthe use and maintenance o f existing capacity. Indian Railways (IR) continues to be a patient who resists any bitter medicines despite plenty o f prescriptions available. It has recently entered into operating deficits and depends on the central budget for its large investment program. Reforming this sector will require large-scale financial restructuring, involving the shedding (or even ring-fencing) o f its non-core assets or businesses. Government policy also needs to address price distortions arising from the long practice o f cross subsidization from freight to passenger services, which causes excessively high freight tariff and discourages the use o f railways, preventing IR from serving the non-bulk high margin transport market. (The freight traffic o f the Indian railways as a percentage o f traffic units i s a mere 5% in India compared to 79% in China, and Indian roads accounts for 60% o f land transport freight and 80% o f passenger traffic). 3.40 Intheports sector, totalberthcapacity isnolongera serious constraint, since the corporatization o f major ports, and establishment o f an independent tariff regulatory authority, has helped bring in the private sector to develop new ports. However, the efficiency o f existing capacity, particularly inthe older ports, needs improvement. Inthese ports, the low productivity o f port equipment and labor causes delays in turnaround and increases handling costs for cargo and containers. The Figure3.6. Shipping Cost DisadvantagesinTextiles average turnaround time for vessels has improved, from 8.1 days in 1990/91 to 3.7 days in 2001/02 (and insome o f the m 40% n n newer ports, such as the Jawaharlal Nehru Port Trust, the turnaround time i s 1.04 days). But India still has to catch up with international standards, where the turnaround time is inhours, andthis will require strong efforts to modernize equipment and improve labor - 1 w o productivity, together with measures to J IllE.Coast 0W.COaSt 0USA reform customs administration, which currently exacerbates the problem o f Source: World Bank-CII (2202) delays and shipping costs. According to World Bank-CII (2002), the time taken to get goods cleared through customs i s 50% longer in India than inKorea or Thailand, and triple what many OECD countries report. Costs associated with shipping a container o f textiles to the United States are over 20% higher for India compared to Thailand, and 35% higher compared to China (Figure 3.6). 3.41 Promoting greater private sector participation inthe provision and financing o f infrastructure i s a key concern for the GoI. Inthe long run, the government cannot attract and sustain private investment in infrastructure unless it addresses the policy problems that underlie investors' concerns by raising prices to cost covering levels and establishing a sound legal and regulatory framework. 3.42 In the short run, however, and to facilitate the transition from publicly to privately funded infrastructure, various public-private partnerships (PPPs), involving subsidies, risk-bearing, and other 62 forms o f financial support from government, may help attract private investment and close financing gaps, because such arrangements allow government to bear certain risks that the private sector feels it cannot mitigate through other means -- for example, risks related to the demand for services, or the cost o f financing.62 Frequently used instruments for government support to infrastructure projects include cash subsidies, in-kmdgrants, tax breaks, capital contributions and guarantees o f risks, either those under the government's control, or those outside the governments control. In general, instruments such as cash subsidies and tax breaks are not desirable, particularly for countries facing fiscal constraints. Tax breaks, may improve the overall bottom line but not specifically target particular consumer groups, and they can cause serious distortions and create opportunities for graft. Where there are imperfections or gaps inthe financial markets, capital contributions and the guarantee o frisks not under the government's control may be the best instrument to use. Ifthe principal concerns relate to political and regulatory risks, then some form o f government guarantee offering compensation in the event o f these risks occurring may be the most appropriate option. 3.43 It must be stressed that while PPPs may help attract some private financing for infrastructure, they can also risk simply postponing the day of reckoning, and impose serious costs on taxpayers (whether in terms o f foregone taxes or revenues from public assets, increased expenditure, or contingent liabilities on the government's budget).63 Given India's huge unmet investment needs in infrastructure, the most useful impact that a highly selective use o f various public support arrangements could have i s perhaps to help private sector innovators pilot transactions that have good underlying cash flows, but where the private sector cannot carry the full costs o f the policy, regulatory and legal risks, and costs o f public consultation, etc. (in other words, to help provide "icebreaking" services). Beyond that, the success with which private investment in infrastructure can be scaled up will depend less on clever financing and more on the framework underpinningprivate participation ininfrastructure. Inthe long run, government cannot attract and sustain private investment in infrastructure unless the policy, regulatory and legal problems that underlie investors' concerns are addressed. Therefore, PPPs should be seen, at best, as temporary measures and shouldbe entered into with caution. EstimatedImpactof a BetterInvestment Climateon OverallEconomicPerformance 3.44 The potential gains to growth from removing key investment climate bottlenecks have been estimated to be in the range o f 2% to 4% per annum. A study by McKinsey (2001) estimated that addressing the inefficiencies generated by the multiplicity o f investment regulations, distortions in the land markets, and widespread government ownership o f business, would free India's economy to grow as fast as China's, at 10% a year, and create some 75 million new jobs, sufficient not only to ward o f f the looming crisis in employment, but also to reabsorb the majority o f workers displaced by productivity improvements. The World Bank-CII study (2002) estimated that, if each Indian state could attain the best practice in India in terms o f investment climate, the economy should grow about 2 percentage points faster. The survey indicated that, if India could achieve Chinese or Thai levels in distinct investment climate areas where it lags behindthose countries, its growth acceleration would be even more dramatic. For a more detailed discussion on the available instruments for PPPs in the infrastructure sector, based on international experience, and the factors that government should take into consideration when selecting an appropriate instrument, see Basu, Harris and Von Klaudy (May 2003). 63For a discussion on the ways to measure costs associated with various types o f government support and methods to value guarantees, see Irwin(2002) and Irwin,Klein, Perry and Thobani (1997). 63 111.2: AGRICULTURE AND RURAL DEVELOPMENT Agriculture and the RuralEconomy 3.45 The agricultural sector's contribution to GDP has declined from about 35% in 1980/81 to 23% in 2001/02. Despite this, about 75% o f India's poor are currently inrural areas and a large proportion o f the rural poor are dependent on agriculture for employment and as a major source o f livelihood. Analysis o f the NSS 55th round survey (1999/2000) shows that agricultural households64 comprise about 54% o f households in rural areas. In some states, such as Rajasthan and Uttar Pradesh, apcultural households comprise over 70% o f poor rural households. The majority o f cultivators are also small landholders. The large number o f poor agricultural households and their income vulnerability are major concerns among policy makers. These inturnhave driven both agricultural policies (trade protection and private trade marketing controls) and public expenditures (investments and subsidies) in apculture. Improving agriculture's performance, especially increasing foodgrain output to achieve self-sufficiency to meet its food security goals, has also been a major government priority. 3.46 According to the latest Census, about 235 million people (58% o f the total labor force) were employed in the agricultural sector in India in 2001.66 Of serious concem i s the l o w productivity o f workers engaged in agriculture compared to those employed in the non-agricultural sector in most state^.^' This results from the large numbers o f workers tied to agriculture in almost all states, the slowing down of agricultural growth, the shnkmg share o f agricultural GDP and limited opportunities for employment inthe rural non-farm sector. This inturn contributes to the highlevels ofpoverty inrural areas at the state level. 3.47 Inview of the highrates of poverty among agriculturalhouseholds, the large concentration of labor tied to apculture and the low productivity o f these workers, GoI's National Apcultural Policy and the Tenth Plan place highpriority on raising agricultural productivity as a means to achieve more rapid agricultural growth and to reduce rural poverty. At the same time, it has also heightened government attention towards promoting the more rapid growth o f the rural non-farm sector. Promoting both agricultural and rural non-farm sector growth i s vital, because they are closely linked due to the strong backward and forward linkages.@ Promoting rural non-farm sector growth would require improved access to basic infrastructure (roads, markets, electricity, water) and services (market information, credit, education). In opening greater employment opportunities in the rural non-farm sectors, this could create demand for agricultural labor, contributing to higher agricultural wages and incomes. 3.48 Over the last two decades, apcultural growth rates have begun to follow a slowing trend, which will have dire consequences for rural areas and the rural poor inthe longer term ifappropriate actions are not taken to reverse it. The growth slowdown can be traced to the continuing decline in productivity- enhancing investment by the government, which i s leading to the slowdown o f total factor productivity growth in the agricultural sector. Although most Go1 domestic trade restrictions were lifted in 2002, the possibility o f their re-imposition at any time continues to reduce private sector incentives to participate or invest inthe apculture sector. Inthe future, therefore, improving agricultural performance wouldrequire 64Theseinclude households involved incultivation and agriculturalwage labor. 65 Based on the Planning Commissionrural poverty line. 66 These include 128 million cultivators and 107million agricultural laborers. Inrural areas, dependence on the agricultural sector i s even greater. About 228 million workers, or nearly three-quarters o f the rural population, were employed in the agricultural sector. 67 Average labor productivity i s measured by the sector GSDP divided by the number o f workers employed inthe sector. Inmajor states, excluding Punjab and Kerala, agricultural labor productivity on average amounts to about one quarter o f labor productivity inthenon-agricultural sector. `*Forward linkages take the form o f the agricultural sector supplyingproducts for downstream processing or direct consumption, agricultural surplus providing investment funds to the n o n - f m economy, and consumption by agricultural household of goods and services from the non-farm sector. Backward linkages take the form o f the non-farm sector stimulating growth in the agricultural sector by supplying inputs and investing inthe agricultural sector (Lanjouw and Feder 2001, Haggblade et al. 2001). 64 progress in two key policy areas: (a) rebalancing govemment expenditures from subsidies towards more productivity-enhancing public investments, including irrigation, rural infrastructure such as roads, markets, and electrification, and research and extension; and (b) permanently removing restrictions on domestic trade (subject to their imposition only in emergency situations) to improve the investment climate for farmers and the private sector so as to effectively meet market opportunities, while supporting a regulatory framework to ensure fair competition. 3.49 Agriculturalperformance. Average annual agricultural GDP (including forestry and fishing) growth rates displayed a slight slowdown between the 1980s and 1990s (Table 3.4).69Notably, the sector displayed a relatively strong performance in the early 1990s which various studies attribute to a number of factors, including the economic reforms in the early 1990s which reduced the taxation o f agriculture and thus contributed to improving the agricultural terms o f trade, the impact o f increased investments, particularly private investments, in the sector in the 1990s, increasing agricultural diversification into higher value products such as horticulture and livestock spurred by rising incomes and changing consumer preference^,^' and rapidly rising govemment support prices and input subsidies during a period o f good monsoons. Table 3.4: GDP,Agriculture Sector Growth Rates" 1980181- 1989190 1990/91- I999100 1992/93- 1996197 1997198- 2001102 GDP at factor cost 5.6 5.8 6.7 5.5 Agriculture,forestry& fishing 3.4 3.0 4.7 1.8 Agriculture 3.5 3.0 4.8 1.7 Forestry& logging 0.0 0.6 0.1 2.4 Fishing 5.9 5.2 7.7 2.9 Nofes:"Compound annualgrowthrate.% Source: CentralStatisticalOrganization,NationalAccountsStatistics. 3.50 While the recent slowdown in apcultural GDP growth rates (1.8% per annum from 1997/98 to 2001/02) can be largely attributed to successive natural calamities that afflicted various parts o f the country (extensive droughts in many states due to poor monsoons and flooding in some northem states), there i s growing concem regarding whether sustaining past agricultural growth performance, let alone attaining a higher growth trajectory, could be achieved without addressing fundamental structural problems. Several recent studies find total factor productivity (TFP) in agriculture has been declining between the 1980s and 1990s (Kumar 2002, Sharma 2002). Inthe Indo-Gangetic Plains, traditionally the seat o f the green revolution, Kumar finds that while TFP grew by 2% per year between 1981and 1990, it became negative between 1990 and 1996. These and other studies attribute the deceleration in TFP growth to the slow down in productivity gains from the earlier adoption o f high yielding varieties, the decline inpublic investments in the agricultural sector, and increasing natural resource degradation (Box 3.2). 69 The growth rates are sensitive to choice of data periods, inpart due to agricultural productionfluctuations. ' OThe decline in per capita net availability of cereals, between the early and late 199Os, has been flagged by many as an early sign of an impending food crisis. NSS surveys confirm the decline in per capita consumption. Recent studies find that this decline i s not new in India (Hanchate and Dyson 2000 and Hanumantha Rao 2000). It likely indicates a substitution away from cereals to other foods as incomes rise. Deaton and Dreze (2002) find that the consumption o f "superior foods" such as vegetables, milk, fruit, fish and meat rose quite sharply across all expenditure groups duringthis period. 65 Box 3.2: Damaging the Land As recently as 1999, the govemment estimatedthat nearly half ofthe country's 329 million hectares of soil could be categorized as degraded (Go1 1999). One study asserts that the majority o f Indian soil has been harmed, concluding that only 36% o f land area suffers no serious damage. They found that 5% faced low degradation (less than 15% yield loss), 11% was moderately degraded (15-33% yield loss), 43% was highly degraded (33-67% yield loss), and 5% was so damaged that the land became unusable. More importantly, about half o fthe land under use for agriculture, forestry and pasture can be categorized as degraded. A household-level and plot-level study in Uttar Pradesh showed serious damage: waterlogging and salinization led to significant declines in paddy and wheat yields over a ten-year period (Joshi and Jha 1991). This productivity loss leads to significant economic losses. A study from the mid-1990s estimated that agricultural output loss due to soil degradation amounts to about US$1.9 billion per year (Brandon and Hommann 1995). One researcher estimated that waterlogging and salinization caused annual cereal production loss amounting to about 5% o f agricultural GDP (Young 1993). Such economic losses represent short- runeffects, but long-run impacts ofsoil degradation inIndia, such as permanent damage, should also be considered. Dregne and Chou (1992) found that human-induced water erosion led to irreversible soil productivity loss o f 20% or more in certain sections ofIndia. driven by private sector investments, mainly in farm Figure 3.7: Gross Capital Formation in Agriculture equipment, minor irrigation and and Allied Sectors, Rs. billion, 1993194 land improvements (Figure 3.7). By 250 contrast, public investment 3 systematically declined since the 4 200 m i d - 1 9 8 0 ~ ; ~its~ share o f annual d gj 150 agricultural GCF decreasing from .:- zai 44% in 1985186to 23% in2000101. loo This decline is a major cause for - E 50 concern because o f its potential 2 negative impact on agricultural 0 growth over the longer term. Gulati 1960161 197Oii'l 1980181 I990191 2000101 and Bathla (2002) estimate that a --tPublic -E+ Private +Total lo% inpublic investments decrease Notes:*QuickEstimates (including irrigation and power) Source: Ministryof Agriculture, AgriculturalStatistics at a Glance 2002 leads to a 2.4% reduction per year 71According to the Indian System o fNationalAccounts, the public capital formation statistics primarily comprise investments in major and mediumirrigation schemes. Gulati and Bathla (2002) re-estimate public gross capital formation to include investments inpower (Concept 11) and power plus investments made in agriculture and allied activities as defined underbudgetary heads of '*Gulati the govemment accounts (Concept 111).Under both concepts, public capital investments declined. and Bathla (2002) also find that availability o f institutional credit and terms o f trade between agriculture and non- agriculture also has a positive and significant influence on private GCF. 66 etc). The bias towards subsidies also reduces resources for much-needed social investments and appropriate operations and maintenance o f critical rural infrastructure. Indian policymakers have questioned why India should reduce its agricultural subsidies, in view o f the large agricultural subsidies provided by developed countries such as the EU and US. These are issues that clearly need to be raised and addressed through its bilateral and multilateral negotiations (e.g., WTO). However, India's reduction of agricultural subsidies i s no longer purely an issue o f its fiscal costs and o f using its fiscal resources more efficiently. The extent to which these subsidies are eroding the core foundation for sustained agricultural growth over the longer term, due to inadvertent natural resource degradation, i s as or even more critical. The following sections elaborate further on key sectoral issues. Foodgrain(Rice and Wheat) Policy 3.53 GoI's foodgrain policy rests on two major pillars: (a) to ensure farmers a reasonable income through government procurement at a minimumsupport price (MSP) for rice and wheat; and (b) to ensure adequate availability o f and improved access to foodgrains by consumers at reasonable prices through the distribution o f subsidized foodgrains and price stabilization through buffer stockmg operations. To achieve this, Go1created a public marketing system that parallels that o f the private sector. The Targeted Public Distribution System (TPDS), introducedinJune 1997, aims to ensure access by the poor and other vulnerable groups to essential food commodities. The program supplies rice, wheat, and sugar nationally, and other commodities such as edible oils and coarse grains in some states, at subsided prices. The shiftto the TPDS was a significant milestone in GoI's food security strategy, as it targeted a larger share o f the foodgrain subsidy to the poor relative to the n ~ n - p o o r .To ~ ~support TPDS and price stabilization activities, trade restrictions on the private sector were enforced by Go1 and state governments. The Essential Commodities Act, 1955 empowers the Go1 and state govemments to enforce controls on movement, storage, exports and imports, and access to trade credit. Controls were enforced or lifted depending on the severity o f supply shortfalls and price rises, thus eliminating private sector incentives for spatial and temporal arbitrage. In 2002, the Go1 finally lifted the licencing requirements and movement and storage restrictions on private dealers. However, the potential for their re-imposition continues to discourage private investments in the foodgrain sector. Recognizing this, the Go1 i s considering the amendment o f the Essential Commodities Act to permanently remove these trade restrictions, with provisions for their enforcement only in emergency conditions. In2003, restrictions on the use o f riskmanagement instruments, specifically futures contracts, were also removed. 3.54 Steady increases in the minimum support price (MSP) for rice and wheat encouraged increased production, necessitating greater government procurement. However, strong political pressure from states where the largest procurement have traditionally been made (i.e., Punjab, Haryana and Andhra Pradesh) stalled efforts by Go1to contain increases inthe MSP. Combined with the reduction infoodgrain off-take with the shift to TPDS and the downward trendinworld market prices, which limited export possibilities, continued government procurement led to growing buffer stocks, which rose to over 60 million metric tons in July 2002, compared to the norm o f 18 million tons (Economic Survey 2002-03). Consequently the buffer stock component o f the food subsidy rose from 12.5% in 1997/98 to about 41.6% in 2001/02. The overhang of burgeoningbuffer stocks inturn exerted downward pressure on open market prices, and combined with high MSPs necessitated even greater government procurement. In an effort to reduce surplus stocks, the Go1 institutedseveral measures, including increasing the monthly allocations under TPDS for all households, lowering the issue price for above poverty line families, increased use o f foodgrains for welfare schemes and drought relief, open market sales at prices below FCI's economic costs and subsidized exports. In the context o f high MSPs, these measures combined to raise the food subsidybillfurther. ~ 73 Itspredecessor,the Public DistributionSystem, by contrast was a general entitlement scheme, which was widely criticizedfor its failure to serve the populationbelow the povertyline. It was also criticizedbecause it provided meager income and suffered from urban bias, leakage and diversion and deteriorating quality of grain supplied, and lack o f transparent procurement and delivery systems. 67 3.55 Recent analysis o f the impact o f the shift to TPDS indicates increased participation o f persons below the poverty line at the All India level and in most states (Deninger and Umali-Deninger, forthcoming). However, despite this improvement, many o f the poorest are still un-served. The most frequently cited reasons that households cite for not purchasing foodgrains from the TPDS are: "the item was not available inthe ration shop", "not having a ration card", and "unsatisfactory quality." 3.56 Recognizing the crisis created by mounting buffer stocks and food subsidies, Go1established a high-level committee to develop proposals for a long-term foodgrain policy. The report o f the committee was releasedin2002. The committee's proposals to remove the rice levy and all restrictions on foodgrain trade, and its activation only in emergency conditions, will improve incentives for the private sector. However, some o f the other proposals raise concems. The underlying principle o f the proposed policy towards maintaining self-sufficiency that also ties farmers to low-value rice and wheat production will come at the cost o f efficiency. The continued large public sector role envisioned in foodgrain markets will crowd out private sector participation. The proposal to set the Minimum Support Price (MSP) to cover the cash costs plusthe returns to family labor, land and capital i s a positive step. Inthe longer term, however, fostering competitive markets would serve as a better avenue for ensuring remunerative returns to farmers. Inthis scenario, the MSP should be reduced to cover the cash cost only, which complemented by others schemes (e.g., employment schemes, TPDS) would serve as a safety net for farmers. Otherwise this implies that the government will continue to determine farmpricesrather than the market. Finally the proposed reversion back to an untargeted public distribution scheme i s likely to bring back the earlier problems o f the PDS o f subsidies being captured by non-poor households and will likely result in an escalation o f food subsidies. Effectively targeted safety nets, such as the TPDS, would help protect the poor from price and income shocks, while drastic supply shocks would be mitigated by a cost-effective and well-managed price stabilization mechanism. 3.57 There i s broad based agreement in India that the existing foodgrain policy i s not sustainable but there i s limited agreement on the way forward. Significant political economy constraints, necessitating complex negotiations between the Go1 and states which traditionally benefited from large-scale procurement (i.e., Punjab, Andhra Pradesh and Havana), and the considerable inter-dependence among the various interventions (procurement, buffer stockmg and the TPDS), have compounded the complexity o f managing the reform process. Future progress will require difficult decisions that will necessitate strong govemment commitment. Input Policies 3.58 The government's agricultural policy o f the last three decades has relied on subsidizing key inputs to promote more rapid agriculturalproduction growth and ensure food security for its population. This policy is recognized as a key factor in the rapid adoption o f high-yield varieties o f rice and wheat that were the cornerstones o f the green revolution in India in the 1970s and 1980s. There i s also broad recognitionthat the rapidly rising subsidy levels are fiscally unsustainable. Power and irrigation subsidies are a major cause o f the fiscal crises inmany states, and with deteriorating state finance, are crowding out productivity-enhancing public investments such as rural infrastructure, irrigation, and technology upgrading. Power and water subsidies, to the extent that they encourage inefficient water use are also leading to salinity, water logging, and declining groundwater tables in many areas. Fertilizer subsidies, that are largely concentrated on urea, have distorted inputuse. These issues are elaborated below. Fertilizer Policy 3.59 Fertilizer subsidies were introduced in the 1970s inresponse to the sharp rise inthe prices o f oil and feedstock o f the fertilizer industry, and have remained since then. Domestic producers o f urea are given a designated plant specific retentionprice, which i s essentially derived on a cost-plus formula. The fertilizer subsidy given to the firm i s the difference between the retention price and the farm gate price o f fertilizer. Di-ammonium phosphate (DAP) production and muriate o f potash (MOP), which i s generally 68 imported, receive a flat-rate subsidy under a concession scheme. The fertilizer subsidy, which i s now equivalent to 0.4% o f GDP, i s wholly borne by the central government. 3.60 Who are benefiting from the fertilizer subsidies: farmers or domestic fertilizer manufacturers? Gulati and Narayanan (2002) estimate the distribution o f the subsidy based on the difference between farmgate prices o f domestically produced fertilizer relative to imports. While the actual farmer share varies yearly due to the fluctuation in world prices, they find that the average subsidy share o f farmers was about 67%, while that o f industrywas about 33% from 1981/82to 1999/2000. 3.61 Concerned with the rising subsidy costs, Go1established a HighPoweredFertilizer Pricing Policy Review Committee in 1997. Its report, completed in 1998, recommended: (a) deregulation o f the fertilizer industry; (b) discontinuation of the unit-wise retention price; (c) new pricing methodology based on the long-run marginal cost; (d) abolition o f allocations under the Essential Commodities Act; (e) new units to get a guaranteed price for 15 years; and (0 setting up of a Fertilizer Policy Planning Board. In 2001/02, the government announced its policy to rationalize fertilizer pricing and implement the recommendations o f the Expenditure Reforms Commission (ERC) for a phased program o f price increases (7% per year) and complete decontrol o f urea by April 2006. Since then, Go1has implemented a number o f reform actions (Table 3.5). Continued commitment to the proposedtimetable would lead to a significant reductioninfertilizer subsidies over the next few years. Table 3.5: Recent Fertilizer Policy Reforms Budget Period Reform Announcement Reform Actions Taken 2001102 First phase of decontrol to commence on April 1, 2001 Unit specific RPS will be replaced by a Group Concession Proposal for replacement of the Retention Price Scheme by a Group Scheme. Current maximum retail price (MRP) Concession Scheme being prepared by the Ministry of Fertilizers arrangement will be continued and the concession for each group calibrated to enable units to sell urea at stipulated MRP. Concession rate for urea units based on napthalfurnace Implemented in 2001 oililow sulfur heavy stock be linked to international prices of feedstock. 2002103 Urea, DAP and MOP prices increased by 5% and reduce Maximum retail prices of urea, DAP, MOP and complex fertilizers the subsidy on SSP by 501mt. Prices of complex fertilizers increased and rate of subsidy on SSP reduced by Rs 501mt. will be suitably modified 2003104 Issue price of urea will be raised by Rs12 and DAP and [Urea price increase reversed in March 20031 MOP by RslO per bag Implementation of Group Concession Scheme beginning April 1,2003 Source; Budget speeches and implementationof budget announcements from 2001-2003 Water Resources and Irrigation 3.62 The development o f surface irrigation has been a major pillar o f the government's agricultural strategy for increasing agricultural productivity and incomes, fostering agricultural growth and rural poverty reduction, and reducingvolatile production fluctuations due to weather risks, thus improving food security. Public investments in surface irrigation accounted for a major share o f expenditures in agriculture. Owing to increasing costs o f expanding irrigation projects to more difficult areas, and higher costs o f borrowing, capital expenditures at the national level have increased from about Rs.53.5 billion in 1985/86to Rs.63.1billion in2001/02 (constant 1993194rupees) or approximately 24% o fthe total central 69 and state capital expenditure^.'^ These investments contributed to an All India increase in net surface irrigated area from 15.7 million hectares in 1981/82 to 17.7 million hectares in 1998/99. 3.63 Water resources management is a state subject. A major challenge facing the water sector in all states i s the increasing inter-sectoral competition-between agriculture, the largest consumer, and other sectors such as industry, drinking water and other users, for increasingly scarce water (surface and groundwater) resources. In some areas, drinking water supplies have reached crisis levels due to over- extraction o f groundwater. Insurface irrigation (major, mediumand minor), the sector i s suffering from a vicious circle resulting in the degeneration o f existing infrastructure adversely affecting agricultural productivity, while contributingto the fiscal crisis inmany states. 3.64 Who benefits from surface irrigation and its associated subsidies? Ingeneral, small and marginal farmers account for the major proportion using canal irrigation. The distribution o f canal-irrigated land according to farm size, however, varies considerably by state. In 10 o f the 15 major states examined, small and marginal farmers accounted for half o f the total canal irrigated area (World Bank 2003). Household level analysis o f the incidence o f canal irrigation subsidies in Rajasthan, however, finds that its distribution i s regressive, with a marginal farmer receiving about a tenth o f the subsidies received by a large farmer (Sur and Umali-Deininger 2003). 3.65 GoI's national water policy (2002) aims to address the above constraints, by ensuring the long- term sustainable allocation and efficient use o f the country's increasingly scarce water resources by promoting the adoption o f a comprehensive and integrated approach to planning and management o f water resources on a river basin basis. It puts priority on rebalancing expenditures from the creation o f new assets to demand-driven investments in rehabilitation and maintenance o f infrastructure through greater participation of users in managing systems. It promotes cost recovery o f at least Operations and Maintenance (O&M) costs to ensure longer-term financial and fiscal sustainability o f operations. And it seeks to reorient water agencies towards greater attention to clients and the delivery o f good quality water services. Several states have began to adopt these reform measures invarying degrees, including Andhra Pradesh, Kamataka, Maharashtra, Rajasthan, Tamil Nadu, and Uttar Pradesh. As water i s under the purview o f state governments, the challenge inthe future i s to encourage states to adopt the whole reform package. 3.66 As a start, Go1recently introduced an incentive program to encourage cost recovery o f O&M costs under the Accelerated Benefits Program by providing central assistance for the completion o f "last mile" projects. During the Tenth plan period, Rs.95 billion have been allocated. So far, Rajasthan, Madhya Pradesh, Orissa, Maharashtra and Uttar Pradesh have availed o f these resources. In 2003, Go1 established a task force to look into the feasibility o f inter-linking rivers as a way o f transferring water from surplusto deficit areas. Power Supply toAgriculture 3.67 In 1997/98, about 57% o fnet irrigated area inIndia was irrigatedusinggroundwater. The use of electric pumps for groundwater irrigation has been critical for expanding irrigated area, which in turn contributed to the growth in agricultural productivity and aggregate output. I t s positive impact on agricultural productivity has been shown in various studies. Studies at the village level found that the use o f electric pumps for irrigation increased aggregate output growth by 2 percentage points (World Bank 2002i). A study on the cost of un-served energy found an estimated loss in crop production o f 3.1% o f agricultural GSDP in the state o f Haryana and 13.3% for Kamataka (Tata Energy Research Institute 2000). 74 The public sector gross capital formation statistics from the national accounts and the capital expenditures based on the govemment budget differ considerably. The irrigation capital expenditure estimates, which primarily make up the agriculture gross capital formation, exceed the reported agriculture gross capital formation figure, due to differences in definition. 70 (World Bank 2001). Motor burnouts Figure 3.8: Electric Pumps Only: Irrigation Cost as a Percent of that cost about Rs.1,000 to Rs.4,000 Gross Farm Income in Haryana n r to repair each time impose undue I 53 7 s burden especially among the small d 30 and marginal farmers. They account .- sg 25 for about 10% o f gross farm incomes 20 for marginal farmers in Haryana and 115 U J about 8% o f gross farm income for .-c 10 -- marginal farmers in Andhra Pradesh c t 5 (Figure 3.8). Notably, electricity v) 0 tariffs account for a small but Marginal Small Medium Large Overall regressive share o f gross farm incomes. The study simulated the impact o f tariff increases with and Nofes: Pump maintenance includes travel costs for repair and other costs. Motor bumout consists c motor revinding cost. Fixed costs per year cover pump and well investments. Some farmers have without improvements in the quality zero fixed costs, as pumps are fully depreciated (assuming 20 yrs lifespan). o f electricity supply. It found that Source: World Bank 2001. improvements in quality o f supply could more than compensate farmers for the increase intariffs. 3.71 The present model o f subsidy delivery mechanism to agriculture is inefficient and ineffective. A large proportion o f farmers who are not using electricity for irrigation do not benefit from the subsidies. Those who are connected do not receive adequate electricity services because the utilities are unable to finance investments due to low cost recovery. India should move towards adopting a more transparent and targeted subsidy delivery mechanism for agriculture. For such an alternative model to work, it i s indispensable that there i s cost recovery o f at least operating costs, universal metering o f consumption, payment discipline, and improved delivery efficiency o f electricity providers. 75 Metered power supply was universal practice in India till the mid 1970s and 1980s. As SEBs faced increasing problems o f pilferage, poor collection efficiency, and large numbers o f corrupt meter readers, the shift was made to flat tariffs (Kishore, Sharma and Scott 2003) 71 ProductandFactorMarkets TradePolicies and Regulations 3.72 While economic and trade reforms in the 1990s have improved the incentive framework for agriculture, higher growth i s increasingly hampered by the over-regulation o f domestic trading activities for major agricultural commodities. These have included small-scale reservation and controls on storage, transport, processing, credit, exports/imports, etc. under the umbrella o f the Essential Commodities Act 1955 (Table 3.6). In addition, most states legislated Agricultural Product Market Acts, which not only restricts the development and operation o f wholesale "regulated" markets for agmultural products to the state government, but also forces farmers within a defined area to sell only through these regulated markets. These regulations unnecessarily increase transaction costs and market risks and uncertainty and hurt the agricultural sector, because the resulting marketing margins put downward pressure on farm prices, increase the costs for consumers and reduce the competitiveness of, and potential demand by local consumers and exports. Table 3.6: Go1Major Domestic Policy and Trade Regulations, January 2003 REGULATION RICE WHEAT SUGAR OILSEEDS/ COTTON LIVESTOCW EDIBLE OILS PRODUCTS Central Government Movement controls Storage controls Zoning Small Scale Reservation Selective Credit Controls Jute Packaging Rqt Minimum Price support Consumer Price Subsidy ExporVlmport Futures Banned State Governments Mill Commodity Levy Marketing controls Storage controls Price support Consumer Price Subsidy Notes Shadedcells-commodity requlationexists. Lifted-commodityrequlationtemporarilv not enforced.These commodities . - accountfor about two-thirdsofag&ultural GDP. Source: Staff estimates 3.73 While the licensing requirements and movement and storage restrictions for rice, wheat, coarse grains, edible oil, oilseeds, and sugar were lifted in 2002, the continuing uncertainty regarding their possible re-introduction discourage private sector investments, both local and foreign, in marketing and ago-processing and industrythat could have expanded demand for primary agricultural products as well as generate additional employment inrural areas. Moreover, while Go1has lifted these regulations, some state governments continue to enforce some controls (e.g., cotton marketing controls in Maharasthra). A consensus has emerged, however, inthe Go1and state governments on the reform o f the state Agricultural Produce Markets Acts to permit greater private sector and cooperative involvement in wholesale market development as well as to remove the restrictions on farmer marketing options. A Go1 taskforce i s 72 currently drafting a model Act. So far, only Kamataka has made minor amendments to allow NDDB to set up a fruit and vegetable wholesale market and Punjab, Haryana, and Madhya Pradesh have allowed farmers under contract farming arrangements to by-pass the wholesale markets and sell directly to the private buyer/contractor. 3.74 The reduction in manufacturing protection and exchange rate devaluations, which started in 1991/92, substantially reduced the overall anti-agricultural bias o f the system (Blarel, Purse11and Valdes 1999). After 1997, however, several major aspects of the extemal environment changed, which had important repercussions on India's agricultural trade policies. The quantitative restrictions on agricultural consumer goods imports were abolished in April 2001, at a time when world prices o f some major commodities produced by India (e.g., foodgrains, edible oils and oilseeds, cotton, and rubber) declined substantially, reinforcing local pressures for increasedprotection. At the same time, Indian policymakers developed a more pessimistic view of the prospects for world agricultural trade liberalization, especially following the massive new subsidies introduced by the 2001 US Farm Bill. Inresponse, Go1has raised agricultural tariffs, so that they are now above the average non-apcultural tariffs. In 2003/04 the un- weighted average rate (including the S A D tax) i s about 46.8% compared to about 30.7% for non- agricultural tariffs. But with few exceptions, India i s no longer explicitly taxing or usinglicensing, export bans or quotas as it did inthe past to restrict agricultural exports and depress domestic prices. 3.75 Even though Indian agriculture as a whole remains internationally competitive, there are dangers for its efficient development, given the present direction of increasing trade protection. Experience world-wide, especially in agriculture, shows that high protection will sooner or later create high cost production, as land, labor and capital move to produce products protected by highbarriers to imports, at the expense o f other products where pro-protection lobbies are less effective. Exporters and exports are typically major losers in this process, since they have to compete inworld markets without protection. In this perspective, it would be in India's interests to reduce its WTO agncultural tariff bindings to much lower levels, as a way of providing an extemal constraint on domestic lobbies pressing for high protection. As one o f the world's largest apcultural economies, India directly influences the world markets o f many agricultural products. If it follows open, predictable, non-interventionist trade policies it can broaden these markets and reduce their instability, but ifIndia intervenes excessively to protect its domestic market against instability in world markets, it i s large enough to further increase international instability, which in turn reinforces protection and intervention in other countries. Figure3.9: Percentage Distributionof Number of Owned Holdings and Area Owned by Farm Size Access to Land 3.76 The agrarian structure in India 60 n has undergone significant structural transformation since the 1970s. The distribution o f land ownership has become less skewed (Figure 3.9).76 The trend towards landlessness also appears to have been arrested, with the percentage o f landless between 1982/83 Numberof Holdings Numberof Holdings Area Owned(71i72) Area Owned(99100) (71172) (99100) and 1999/00 remaining at around 11%. 0Marginal 10Small Semi-Medium The two critical factors driving this Nofes: Marginal -0.1to lessthan 1 ha. Small 1to 2 ha. Semi-medium 2 to 4 ha.to 10 ha. and - - process have been the government's large - 10or more ha. land policies and demographic Source: 1971/72and 1992193NSS surveys, as cited in Vyas 2002; 1990100NSSsurvey- Klaus pressures (i.e., farm break-up through Deininger,mimeo 76These figures do not account for land quality. The ceiling on land ownership varies across states and depends on the quality o f the land(e.g., dryland, irrigatedlandwith one or two crops). 73 inheritance) though the contributiono f each o f these i s open to some debate. 3.77 Under the Constitution, state governments have the responsibility for land reform. All states completed the passing o f landreform legislations in 1972. These legislations focused on: (a) the abolition of intermediaries between the state and the cultivator; (b) the imposition o f land ownership ceilings and distribution o f surplus lands to the landless; (c) tenancy reforms to provide security o f tenure and regulate fair rent; and (d) consolidation o f holdings to prevent their further fragmentation. The land ceiling, the redistribution of surplus land and the purchase o f land by tenants contributed to the changing land ownership structure in India. However, it appeared to work more through encouraging land subdivision rather than the sale o f surplus land to the poor. Government purchases o f ceiling surplus land for re- distribution to the landless have been very limited in virtually all states. Today, because o f declining average farm sizes in all states, there i s increased debate on the land ceiling legislation. Another area o f increasing concern i s ensuring legal recognition o f property rights o f women that have been neglected in earlier land legislations, for example, to redress gender inequalities in existing succession legislation for Hindu women as well as customary laws to provide inheritance o f property from other religious communities (Saxena 2000b).~~ 3.78 Tenancy restrictions vary by state and range from a total ban to almost complete freedom of These laws, however, had unintended adverse impacts, including large-scale self-cultivation by landlords or the adoption o f wage labor contracts. Appu (1997) estimated that tenancy legislations were associated with the eviction o f more than 100 million tenants, which caused the rural poor to lose access to about 30% o f total operated area. Furthermore, the legislation has driven tenancy underground inmost states, thereby reducing the scope for greater land access through rental markets and the tenant's bargainingposition and ability to enforce contract terms. These restrictions are also limitingthe ability o f the increasing number o f marginal and small farmers to use their labor more productively, whether in farming by renting inland, or renting it out to take advantage o f higher-payingnon-farm opportunities. 3.79 There i s a growing consensus, as reflected in a number o f recent government policy statements (e.g., National Agricultural Policy 2002, Tenth Five-Year Plan, Karnataka Agricultural Policy 1995) about the need to revisit and re-formulate current tenancy legislations. In considering tenancy reform, it would be critical to draw lessons from experience in states that do not have any tenancy restrictions. More importantly, there are some states where the benefits from relaxing tenancy laws are likely to be higher than inothers, due to the more advanced commercializationo f agriculture (and significant amounts of informal leasing) and stronger political commitment to reform. These states could serve as starting point for pilots and could yield important insights for the policy debate and subsequently serve as a basis for broader implementationo f tenancy reform initiatives inother states. 3.80 In 1997/98, the Department ofLandResources introduceda Centrally SponsoredScheme to pilot computerization o f land records in selected districts nationwide. Its objective was to promote greater efficiency through faster information retrieval, transparency and cost reduction. Some states, such as Karnataka and Maharashtra, have not only scaled-up the program statewide, but have also implemented the program in partnership with the private sector. These initiatives reportedly have contributed to more efficient and rapid service as well as reduced opportunities for corruption through increasedtransparency. Over the longer-term, the focus would need to shift towards a more holistic approach to improving land administration systems at the state level. To be successful, the land administration system would need to meet several other key standards o f performance, including security, cost effectiveness, fairness, clarity, simplicity, and sustainability. States could draw on considerable internationalexperience inthis area. 77 For example, in Haryana, Himachal Pradesh, Jammu and Kashmir, Punjab, Delhi and Uttar Pradesh, women can only hold ''limitedtenancy rights on the land and on her death, the holding goes to the heirs of the last male landowner and not to her heirs. Tenancy is totally banned in Bihar, Gujarat, Kamataka, Kerala, Manipur, Orissa, Rajasthan, Jammu and Kashmir and Uttar Pradesh, while there is almost complete freedom o f rental inAssam, Punjab and Haryana. 74 Access to Rural Credit 3.81 India has a wide network o f rural finance institutions (RFIs), but a large number o f the rural poor remain under-served or completely left out o f the formal financial system. There are over 30,000 commercial bank branches, over 14,000 regional rural banks (RRBs), and over 100,000 rural credit cooperatives (RCCs) in addition to several non-bank financial institutions. This translates to about 4,700 people served by each RFIoutlet. However, the last available rural household survey (Reserve Bank o f India 1991) found that only about one-sixth o f rural households borrowed from formal RFIs. Non- institutional sources accounted for as highas 52-62% o f household outstanding debt. The rural non-farm sector also faces constraints to accessing finance. A recent study covering some 20 million small-scale rural enterprises (in the unorganized sector) found that commercial banks reportedly meet merely 4% o f the credit needs o f this sector, and micro-finance sources provide another 3% o f their credit needs. Various estimates suggest that India's rural poor rely almost entirely on informal sources (money lenders, traders, commission agents, etc.) to meet their consumption credit needs, at annual interest rates ranging from 36% to 120% per annum. 3.82 A key factor constraining improved access to rural credit relates to inefficiencies in the formal rural finance institutions (RFIs). Several task forces/committees set up by Go1have concluded that the weak financial health and poor performance o f a large number o f RFIs prevented them from performing their function o f providing credit to rural areas." Most R R B s report losses, despite major government efforts to recapitalize and reform them. Cooperative banks in general, and RCCs in particular, are also performing poorly. This i s largely due to governance and management weaknesses, which in turn result from pervasive government control inresponse to an inappropriate legal framework and weak regulation. Inaddition, the existing legal/regulatory framework stifles innovation. Rural access to finance is further constrained by the inefficiency o f rural financial markets, which i s characterized by interest rate "caps" requiring banks to price small loans within a range o f 2% above or below the prime lending rate. These caps have the perverse effect o f rationing credit to small rural borrowers, as banks prefer not to lend at all than lend at these rates, and small rural borrowers are forced to borrow from the informal sector, where money lenders charge exorbitant rates. 3.83 Both the govemment and RFIs can play an important role in devising market-based solutions to help the rural poor access a larger range o f financial services more easily, and on less costly terms. Future priorities for the government should include: (a) liberalizing interest rates by removing the existing interest rate "caps" for small loans; (b) improving credit information on rural households, by designating an agency that could take the lead in collecting and disseminating information on micro borrowers; (c) facilitating the scaling-up and sustainability o f existing low-cost micro-finance models, such as the self-help group-bank linkage model as well as the Grameen bank replicators, that have been piloted in various parts o f India, particularly in the South, so as to make finance accessible to the poor; and (d) removing legal and regulatory obstacles to the development o f innovations that can help reduce the costs and risks associated with rural finance. The government should also aim to improve the performance o f the regional rural banks (RRBs) and rural credit cooperatives (RCCs) through enhancing regulatory oversight and supervision based on internationally accepted prudential norms; reducing government control and ownership, which, inthe case o f RRBs, would require an amendment to the existing law, and in the case of RCCs, would require states to adopt the recently enacted Model Cooperatives law; strengthening corporate governance; improving management and staff slulls, particularly in the area o f credit decisions and risk assessmentlmanagement; and strengthening the legal framework to make it easier for RRBs and RCCs to recover small loans and to facilitate the use o f land as collateral. ''Report of the Task Force to Study the Cooperative Credit System and Suggest Measures for its Strengthening (Capoor et a1 1999); The Joint Committee on Revitalization Support to Cooperative Credit Structure (Purkayastha et a1 2001); Report of the Expert Committee on Rural Credit (Vyas et a1 2001); Report of the Working Group to Suggest Amendments in the Regional Rural Banks Act (Rao et a1June 2002). 75 Enhancingthe Productivityof PublicInvestments 3.84 Increased emphasis on productivity-enhancing investments, such as agricultural research and extension, irrigation and rural infrastructure i s critical to enhancing agricultural productivity, rural non- farm sector growth and rural poverty reduction. Indeed, Fan, Hazel1 and Thorat (2000) estimate that a 10% increase in government expenditures on apcultural research and development, irrigation and rural roads contribute to a 2.6%, 0.4%, and 0.6% increase in total factor productivity and a 0.6%, 0.1% and 0.5% reduction inthe rural poverty rate, respectively. For these sectors, however, hture challenges lie not only on the needto increase investments, but also on the immediate need to improve the quality o f public spending, particularly a greater focus on operations and maintenance, that also necessarily involves significant institutional reforms. Agricultural Research and Extension 3.85 India's public agricultural research and extension service i s one o f the largest in the world. Agricultural research i s primarily under the purview o f GoI. The public agricultural research system, overseen by the Indian Council o f Agricultural Research alone includes 184 institutes, centers, directorates, and special projects and programs and 29 state agricultural universities with a research staff o f over 30,000. The extension system i s primarily under the purview o f the state government, although ICAR also operates 261 Krishi Vigyan Kendras (farmer science centers) and 8 trainer training centers (ICAR 2002). The public agricultural and extension services have played a pivotal role in promoting agricultural productivity and output growth, especially during the green revolution in the 1970s and 1980s. However, over time, their efficiency and cost effectiveness are increasingly called to question. 3.86 Agricultural research. During the Ninth Plan (1997/98-2001/02), the budget outlay for the public agriculturalresearch system amounted to Rs 67 billion or 0.8% o f agricultural GDP. While there i s room for increasing budgetary allocations further, there i s also an urgent and immediate need to first improve the effectiveness o f existing expenditures. Critical weaknesses o f the ICAR system include crop (bias towards rice and wheat, inadequate priority to post-harvest and gender-related and environmental conservation issues) and regional (inadequate emphasis to the needs o f rain-fed areas) imbalances in research priorities and resource allocations, multiplicity o f agencies at times leading to duplication, inadequacy o f collaborative multi-disciplinary research, weak interaction between researchers, extension workers, farmers and the private sector, excessive centralization o f planning and monitoring, and lack o f accountability for performance (Vaidyanathan 2002, ICAR 2002). 3.87 Private sector participation in agricultural research i s increasing in India, especially with the advent o f biotechnology and the adoption of recent key policies, including the Plant Variety Protection and Farmer's Rights Act (2002), National Seed Policy (2002) and National Seed Act (in draft) aimed at the protectiono f intellectualproperty rights. However, private sector participation tends to focus more on higher value crops inbetter-endowed areas. Public sector researchwould needto increasingly address the problems o f poorer farmers in less-endowed regions (Hanumantha Rao 2003). Thus, what i s needed i s a more regionally differentiated research strategy. Greater consultation and coordinationbetween the public and private sectors would also minimize duplication o fresearch efforts. 3.88 Agricultural extension. The agricultural extension systems at the state level, which are based on the training and visit (T&V) system with its top-down, narrow crop-focused approach, has become outmoded and ineffective inmeeting the changedneeds o f farmers. Inmany states, tight fiscal constraints have led to the breakdown o f the state extension machinery (Hanumantha Rao 2003). At the same time there i s increasing participation o f the private sector in providing extension to farmers. Cooperatives, input suppliers, traders and private extension providers have also become an important source o f information for farmers. Inthe future, improving the effectiveness o f the public extension system would require reforms to make them more demand-driven and address the broad information and technical needs o f farmers, taking advantage of major advances in communication technologies and innovative delivery mechanisms. There i s also a need to build greater synergies between public and private extension efforts. 76 The Ministry o f Agriculture formulated a new "Policy Framework for Agricultural Extension" in 2002 whose key priorities include the adoption o f a farming systems approach through multi-agency (public and private) delivery systems, greater farmer participation (including women) in planning and implementation, increased use o f innovative information technologies, and initiatives for increased financial sustainability and cost effectiveness. The future challenge lies in promoting the adoption and implementation o fthis policy at the state level. Rural Roads 3.89 India's rural road network faces two major problems. Firstly, about 40% o f the rural villages are not yet connected by all-weather roads to market centers or main road networks. These unconnected villages are often cut off from the outside world for long periods duringthe monsoons. It i s estimated that 20-30% of the agricultural, horticultural and forest produce get wasted due to lack o f roads to carry the produce to markets and processing centers. Secondly, much o f the rural road network i s poorly maintained, thus heavily deteriorated. Due to poor maintenance o f bridges and culverts, many existing rural roads become practically impassable duringthe rainy season. 3.90 Most government programs, however, suffer from the lack o f a carefully designed policy and institutional framework to ensure the sustainability o f these investments. For example, All India ruralroad maintenance requires about Rs.50 billion per annum, but only 20-30% i s generally available. Politicization o f investment decisions bias resource allocation towards investment, resulting in gross neglect o f maintenance and diversion o f maintenance funds to fresh construction. Consequently, this results in premature deterioration o f the road assets and a huge backlog o f maintenance. Moreover, the quality o f construction and maintenance work i s generally poor, resulting in overall low service life o f the roads. The multiplicity o f agencies involved in roads further increases the complexity o f rural roads development and management. 3.91 The Go1 gives priority to improving the connectivity o f villages through several centrally sponsored programs. Rural roads generally received about 50% o f funding from various government employment generation programs. Go1 i s committed to providing all-weather roads to the remaining unconnected villages, involving upgrading or constructing about 1.1 million lano f ruralroads at a cost o f about Rs.l.1 trillion. In 2000, Go1 launched a national program called "Pradhan Mantri Gram Sadak Yogna" (Prime Minister's Rural Road Program), which aims to provide all-weather road access to all habitations with over 1,000 people by 2003 and those with populationo f over 500 by 2007.80 3.92 To ensure greater consistency, the Ministry o f Rural Development (MoRD) should take leadership in the policy and institutional changes that are essential, as well as in financing, technology transfer, humanresources development, and monitoring o f rural road development indifferent states. The Pradhan Mantri Gram Sadak Yojana can be an important potential instrument for Go1to influence state- level rural road sector reform. If the program is properly structured and tied with policy reform commitment and outcomes, the program can provide a powerful incentive for change. Panchayat Raj bodies at district, block and village levels are expected to play an increasingly pivotal role in the construction and management o f rural roads. Community participation offers significant potential for mobilizing the support o f local communities in resource generation, land acquisition, and tailoring the rural road programs according to local needs. The major source o f funding o f the program i s the Central Road Fund with revenues from an earmarked tax on diesel and gasoline. The allocation to rural roads amounted to Rs. 25 billion in2001. 77 Rural Electrification 3.93 India's rural electrification program has in the past focused on extending the grid supply to villages and remote areas, thereby resulting in coverage o f 85%" o f the villages and electrification o f 13 million irrigation pumps.Access by rural households, however, remains low at 31% (All India household access rate 52%), and electricity-based economic activities in the electrified villages are minimal. About 77% o f the rural poor and 31% o f the urban poor remain unconnected. During the 1990s the rural electrification program slowed down, and the supply conditions inrural areas deteriorated. The policy o f various states has been to subsidize electricity prices for agnculture and domestic use rather than improving access to the consumers. Often the rural areas face extensive power cuts (scheduled and unscheduled), much more than what urban areas e~perience.'~About one tenth o f the households reported adverse impact on their livelihood, and among the salarieclhusiness category households this was reported by one-forth o f the respondents (Tam 2001). Provision o f adequate and reliable grid supply i s increasingly becoming untenable given the financial and operational difficulties plaguing the power utilities. 3.94 The Government o f India plans to accelerate the electrification program and has set a target for coverage o f all the remaining 62,000 un-electrified villages by 2007 and 100% household connections by 2012. The remaining 18,000 remote villages are to be electrified by 2012 through the use o f non- conventional technologies. Funds have been made available under the Prime Minister's Gramadaya Yojna (PMGY). For strategic and implementation support, the Ministry o f Power has recently set up a high-level commission for renewable energy. 3.95 To facilitate electricity service delivery for agriculture and rural development, a conducive policy environment will be required, including: (a) adequate incentives for the service provider, at the minimum the agriculture and residential tariffs should cover the operating costs; (b) early subsidy reform to bring subsidies to a fiscally sustainable levels and to enable more effective targeting o f poorer farmers and rural consumers; (c) encouraging cost effective technical designs o f rural networks and exploiting the scope for reducing the construction and operating cost o f rural electrification; (d) improving affordability o f connection charges through subsidized connection charges and financing o f the capital subsidy for the service provider through innovative models of subsidy provision; and (e) a supportive regulatory regime for rural supply. Decentralized generation should be incorporated into the rural energy service company model to augment power supply, provide voltage support and reduce transmission losses. These steps to reformthe policy environment for rural electricity supply needs to be put inplace inparallel with reforms aimed at more conventional privatization o f the commercially viable parts o f the sector. InIndia village electrification is defined as the existence o fat least one electricity connection within the revenueboundary o f a particular village. A village couldjust have a single connection to the house, or an agriculture pump and it would be considered as electrified by the utility and planning agencies. 82 InKerala one-fifth o f consumers surveyed in2000 reported power cuts, 98% o f which were from the rural areas. InHaryana (2000), one third rural households reported frequent power cuts, and in Andhra Pradesh (2001) 40% o f the rural households reported dissatisfaction. 78 PARTIV:DEVELOPMENT PROSPECTSAND RISKS 4.1 India's economic growth over the past two decades has been one o f the world's highest among large countries. In an outcome few might have expected in the late 1970s, growth jumped from an entrenched 3.5% per annum to close to 6% over the 1980s and 1990s, substantially reducing poverty. Although progress in improving other indicators o f living standards has been uneven, there has been real progress in some areas such as education. These are real achievements for India. Because around one thirdofthe world's poor live inIndia, these are also achievements o f global significance. 4.2 While India's economic and social performance has been remarkable when compared to its own past, it i s far behind that o f its main competitors in East Asia, in particular China. Poverty remains widespread, average incomes low, and social indicators poor. Moreover, a growing gulf has emerged between the richer and poorer states within the country. Accelerating development requires improving the delivery o f health, water and sanitation, and education, and setting India on a higher growth trajectory. 4.3 Many o f these goals are reflected in GoI's Tenth Five-Year Plan for 2002/03 to 2006/07, which targets an average growth rate o f 8% per annum and rapid progress across a wide range of living standards indicators. Ifthe trends o f the past decade continue, however, the goals o f the Tenth Plan (and the less ambitious Millenium Development Goals) cannot be achieved. Growthhas fallen inrecent years, to below 6% per annum between 1997/98 and 2001/02, and below 5% in 2002/03. Loose fiscal policies and a slowdown inthe pace o f structural reform have been likely contributors to this growth deceleration. Although a recovery may take place in 2003104, India's current growth trajectory appears closer to 5%, than to the desired 8% per annum. And the rate o f progress in improving social indicators i s insufficient to meet GoI's goals. A comprehensive set o f reforms, as discussed inthis report and summarized in Box 4.1, could unleash faster growth and improve delivery o f key services. The remainder o f Part lV discusses the outlook for the Indian economy under baseline and reform scenarios, and highlights the main fiscal, political and external risks for the Indian economy. Outlook 4.4 Growth. The Tenth Plan period started with a further deceleration o f growth in fiscal year 2002103 to an estimated 4.4%, partly as a result o f external shocks or influences. Agncultural output declined by 3% due to flooding in some areas and drought in others. Industrial and services output growth remained above 6%, despite depressed global demand. The degree to which global demand affects domestic output (with the exception o f IT output and exports) remains limited, however, domestic demand and the policies that affect it are still largely responsible for India's output performance. 4.5 Baseline scenario. In the absence o f major external or domestic shocks, and in spite o f the expected recovery in 2003/04, the continuation o f current policies will translate into a continued growth slowdown over the Tenth Plan period (Table 4.1). Without a major reform impetus, it i s unlikely that GDP will average much more than 5% per annum between 2002/03 and 2006/07. Agricultural output i s expected to recover from the 2002/03 slump, and subsequently return to the previous trend. Industrial sector growth i s expected to remain at between 5% and 6% per annum, although the lagged effect o f the contraction in agnculture on industrial output may dampen this recovery in 2003/04. Services, the fastest growing sector over the 1990s, can be expected to continue expanding rapidly throughout the period, albeit at rates slightly lower than those o f the past five years, as large civil service wage increases are unlikely to be repeated, given the existing fiscal crisis. Although growth in IT-enabled services may expand rapidly, it i s also unlikely that the IT sector will continue to expand at rates comparable to those o f previous years. The speed o f recovery in global demand will be important to continue fueling growth in services. 79 Table 4.1: Macroeconomic Projections Baseline and ReformScenarios - Ninth Plan Baseline Scenario Reform Scenario 1997198-2001/02 2002103-2006107 2002103-2006107 Real GDP growth at factor cost (% per annum) 5.5 5.0 6.5 Agriculture, forestry and fishing 1.8 1.5 2.2 Industry 4.5 5.3 7.1 Services 8.1 6.4 8.0 Investment (% of GDP) 22.5 20.5 27.7 Public 6.6 6.4 7.3 of which: general government 3.1 3.0 3.7 Private 15.9 14.1 20.4 Consumption (% of GDP) 78.8 80.5 73.5 Public 12.5 12.0 12.4 Private 66.3 68.5 61.1 General Government (% of GDP) Fiscal deficit 9.3 11.8 10.3 Primary deficit 3.5 3.6 2.2 Source: 1997198to 2001102 - CSO; 2002103 to 2006107 - Staff Projections 4.6 Reform scenario. A comprehensive reform program could improve the outlook for the Indian economy considerably by providing new impetus to growth and accelerating improvements in social indicators. Although it i s unlikely that an average annual growth rate o f 8% could be achieved, it would be possible to gradually set growth on a higher trajectory and reach 8% by the end o f the Tenth Plan period. Because o f the low initial growth rate in2002/03, this would translate into an average growth rate of 6.5% per annum over the Tenth Planperiod (Table 4.1). 4.7 The reforms underpinningthe above reform scenario are comprehensive, and would be expected to have an impact across the board, during and beyond the Tenth Plan period. Reforms to reduce fiscal imbalances at the center and state levels would reduce crowding out and create space for increased private investment. Improvements in the composition o f public expenditures, with a lower share spent on civil servants' wages, pensions, and interest, and on covering power sector losses, and a higher share spent on O&M and investments inkey infrastructure, would further L`crowdin" private investment. Improvements in the investment climate, through the removal of bottlenecks in product and factor markets and key infrastructure would increase the productivity o f both public and private investment across the economy, including in India's poor rural areas. An increased contribution o f FDI would contribute technology transfer and would increase output. More effective delivery o f health, education and safety nets would help accelerate progress in social indicators, empowering India's citizens to both contribute and benefit from faster economic growth. 4.8 Accelerating growth and poverty reduction in India cannot be achieved without also accelerating growth in India's lagging states. If the trends o f the past few years continue, i.e., if growth continues to be divergent across states in 2002-07 (with poorer states growing no faster than 5% per annum or only slightly better than in 1997-2002), then richer states would have to grow at near 10% per annum on average in 2002-07 to reach an all-India average o f 6.5% per annum. This i s a rather unlikely scenario. Thus implicit in the envisaged reform scenario is an acceleration o f growth in India's lagging states, without which regional divergences will continue to worsen. For growth to accelerate inlagging states, an 80 important part o f the reform agenda outlined and discussed in earlier parts o f this report (reduction o f fiscal imbalances and improvements in composition o f public expenditures; improvement in the investment climate; and more effective delivery o f health and education services and social-safety nets) must be implemented by state governments, in particular in poorer states. The role of the central government inboth catalyzing and setting the pace for reforms at the state level i s critical. 4.9 Of particular importance for poverty reduction and rural incomes are policies to increase productivity o f agriculture, which has declined between the 1980s and 1990s. In the short run, the removal of subsidies to foodgrains could reduce agricultural output in the few states that benefit the most from these subsidies. However, these are also states where significant agricultural diversification can take place. More importantly, this reformwould release resources for other expenditures, such as researchand extension, rural electrification, and rural roads. Simultaneously, faster growth in industry and continued rapid growth in services can providejobs for the labor force released from agriculture. 4.10 Employment impact. Relative to the baseline scenario, reforms can be expected to have a positive impact on employment. Even though the employment elasticity o f GDP i s less than one (reflecting increased productivity o f labor) and has been declining in India since the 1970s, a higher aggregate growth rate o f the economy Employment to GDP, 1993194-1999100, can be expected to generate higher Table 4.2: Elasticity ofSelected Sectors employment levels (GOI, Task Force on Employment Opportunities, 2001). Estimated Elasticity The composition of growth also Agriculture 0.00 matters. Agriculture, which employs a large share o f the labor force, can be Manufacturing 0.26 expected to continue expanding output Construction 1.oo without increasing employment Wholesale and retail trade 0.55 significantly, reflecting Transport, storage andconstruction 0.69 underemploymentand improvements in Finance, Real Estate, Insurance and Business Services 0.73 labor productivity, and thusincreasing Source: Gol, PlanningCommission,Reportof the Task Force on EmploymentOpportunities, agricultural wages. Over the 1990s, 7Ml1 agricultural growth has had a zero elasticity o f employment, even though it has a strong positive impact on poverty reduction (Table 4.2). The estimated elasticities o f employment to GDP in services and manufacturing, on the other hand, are considerably higher. An acceleration o f growth inthese sectors will have a stronger impact onjob creation. 4.11 Poverty impact. The continuation o f the current growth trajectory is unlikely to make a strong dent on poverty. In the absence o f efforts to reform the agricultural sector, to improve productivity and improve development expenditures for rural growth, it i s unlikely that agricultural growth rates will accelerate beyond the 3% per annum insubsequent years. This will have direct consequences on the pace of poverty reduction in India over the next five years. Given the strong correlation between agricultural performance and wages and poverty reduction in rural areas, an unbalanced growth pattern where agriculture continues lagging behind will do little to accelerate poverty reduction in India. Part o f the rapid progress inreducingpoverty in China i s due to more rapid growth in agnculture, fueled by reforms in the sector. Poverty incidence can be projectedto decline by less than 6 percentage points under the baseline scenario and nearly 10 percentage points under the reform scenario between 2002103 and 2006107. 4.12 External sector. Continuation of recent trends would translate into a modest growth o f merchandise exports over the Tenth Plan period. Recovery in domestic demand, coupled with the government's further planned reduction in import tariffs, however, could lead to some acceleration in import growth. These trends could push the current balance into deficit again. This could be reinforced by a renewed rise in domestic interest rates as a result of competition between public and private borrowers, which could put further upwardpressure on the rupee real effective exchange rate. Part o f any 81 crowding out, therefore, could be reflected in the balance o f payments. In the absence o f any major policy slippage, however, any renewed current deficit i s likely to be moderate. The Tenth Plan envisages a deficit equal to about 3-4% o f GDP by 2006-07, albeit with rather faster growth of both exports and imports than might be likely on past trends. 4.13 Financing such a deficit would require a mixture o f renewed equity inflows and new borrowings from both foreign commercial banks and the bond markets. India's attractiveness to both direct and portfolio equity investors i s likely to require reinvigoration o f the government's privatizationprogram and fresh reforms to enhance domestic industrial prospects. Foreign lenders, in turn, are likely to look for action to tackle the imbalances inthe domestic economy, especially the fiscal deficits o f both the central government and the states. The current high level o f reserves provides a cushion against both domestic and external shocks, although a change in sentiment about the rupee as a result o f continued high fiscal deficits or nervousness about the health o f parts o f the domestic financial sector could lead to some erosion o freserves. Risks 4.14 Fiscal. India's large fiscal imbalances pose a serious threat to sustained growth and development over the medium term. In the short run, the risk of a speculative attack i s reduced by a compliant financial system, a large pool o f household savers, the limited convertibility o f the current account, and a flexible exchange rate. Thus, in the absence o f a rapid increase in interest rates and weakening growth performance, India i s not vulnerable to the type o f collapse suffered by Russia or Argentina inthe short term. Over the medium term, however, there are consequences o f leaving the current fiscal situation unchecked. While current policies have helped reduce external vulnerabilities, they have also kept economic growth below potential, as growing interest payments have crowded out public investment, and high real interest rates have constrained private investment. Slower growth, in turn, speeds up the deterioration indebt dynamics. Even though interest rates have declined over the past 18 months, public debt dynamics have continued to worsen. As interest rates can be expected to increase from the current historical lows, the growth-interest rate ratio which has prevented the current fiscal vulnerabilities from translating into a full-blown macroeconomic crisis could deteriorate. The persistence o f current fiscal trends will, at best, further limit growth andjob creation. Ifthis negative cycle continues, a full-fledged fiscal crisis cannot be ruled out over the mediumterm. 4.15 It is politically easy to downplay this risk,hoping that higher growth and lower interest rates will eventually solve the fiscal problem. However, experience suggests it would be unwise to sit back and wait for such a virtuous circle to emerge. Instead, the central and state governments will have to be pro- active in reducing the fiscal deficit, shifting expenditures into more productive areas, and removing structural impediments to higher private investment and productivity. The sooner the roadmap for these reforms i s put in place, and concrete action taken to show commitment to follow through, the more manageable will be the adjustment path, and the quicker the pay-off in terms o f higher growth and poverty reduction. 4.16 Political. Other risks could threaten India's development prospects. An important risk i s that the comprehensive reforms needed to accelerate development will be delayed due to the primacy o f political concerns, such as general or state elections. Another i s the diversion o f policy makers' attention (and public resources) to other issues, such as the tensions with neighboring countries. Political obstacles to the needed hardening o f budget constraints between the center and the states, in particular those states which yield large political power, are risks that threatens to further deteriorate state level finances and discourage reforming states. 4.17 External. In the short run, expected developments in the external environment cannot be expected to be strong positive forces. The recovery o f the global economy i s expected to be slow. There remain weaknesses indemand inthe world's largest markets Western Europe, Japan, and North America. This will slowdown growth in industry, albeit to a limited extent because India still is a relatively closed 82 economy, but inparticular in services. A slow down in the inflow of remittances i s also likely. At least part o f the increased inflow of remittances observed in India i s likely to have been a one-off episode, motivated by the events o f September 11, 2001 in the U S and resulting partly from a "flight to safety" event. The same trends can be observed in other countries, such as Palustan and Bangladesh. This level of inflows can be expected to weaken, emphasizing India's fiscal vulnerabilities. Conclusion 4.18 India can be rightly proud o f its development record over the past two decades. It reflects the emergence of a much wider consensus about the importance o f opening up the Indian economy to competition. The results in terms o f more rapid growth and poverty reduction are impressive. But India has still fallen behind its main competitors in East Asia - and poverty remains a reality for many Indians, especially those living in the poorer states o f the North and East. The government i s right to set ambitious targets for growth and social development duringthe Tenth Plan. The key now i s to implement the policy and institutional changes needed to achieve these goals. Sustained progress will no doubt be difficult, especially in the politically-charged areas o f labor, power and agricultural re'form. But it also promises highreturns for poverty reduction inIndia. 83 Box 4.1: Summary of Priority Reforms Fiscal Policy Progressivelyreduce the primary deficit at the center and in states by completing tax reforms (eliminating exemptions, bringing services into the tax net, and implementinga uniform state VAT), reducing power sector losses, andphasingout petroleumsubsidies. Reduce financial sector risks by implementingthe new securitization law, linking returns on provident funds and small savings to market benchmarks, and establishing a clear framework for managing state govemmentguarantees. Improvefiscal management by imposinggreater fiscal disciplineon state borrowing andtransfers, breaking down artificial distinctionsbetweenplan andnon-planexpenditures, and consolidatingCentrally Sponsored Schemes. Improvethe compositionof public expenditures, by reducingthe share spent on wages, pensions, interest payments, and agriculturalsubsidies, and increasinginvestmentand O&M for priority social, infrastructure and agricultureprograms. Delivery of Public Services Reduce administrative fragmentation and reform civil service pay policy and pensions. Improve the performance of the civil service and quality of service delivery by improving public access to information, strengtheningaccountability,andreducingpolitical interference. Refocushealth, educationand social safety netprogramson outcomes. The centralgovemment can play an importantrole as anindependent source for measuringprogresstowards agreed goals. Improvethe private market for healthcare throughtraining, public information and accreditation. Priorities for public funds are to provideclean water and sanitation, andto combat communicable diseases (including HIViAIDS prevention). Support the SSA goals by providing increasedpublic resources and improving resource use in elementary education. Schools should be more accountableto communities, with more local autonomy to find the best solutions. Developawell-designedfiscal framework for local govemments,that would guarantee their autonomy and accountability. Flows of funds from the center and states should be dependent on good local fiscal performanceandresourcemobilization. InvestmentClimate for Industry and Services Speed up trade reform by reducingaverage import tariffs and phasingout tariff exemptions, specific tariffs and anti-dumpingduties. Remove other productmarket distortionsby eliminating preferentialpolicies for small-scaleplayers, implementingafull anduniformVAT, andphasingout remainingFDIrestrictions. Reduce inefficiencies in factor markets by easing restrictions on hiring and firing of workers, improving SME access to credit, addressing problems in the use and transfer of land, and updating bankruptcy procedures. Ensure access to reliable power at reasonable costs by rationalizing power tariffs and improving the financialand operationalperformance of SEBs. Address capacity andquality constraintsinthe transport sector by improving public sector performance(for roads andrail), mobilizing private sector investment (including better cost recoveryfor roads), phasing out pricedistortions(for rail), and improvingthe efficiency of existingcapacity (for ports). AgriculturalPolicy andRural Development Put in place a market-based foodgrain policy which protects the poor through targeted safety nets, while mitigatingdrastic supplyshocks throughacost effectiveandwell-managed price stabilizationmechanism. Reduceinput subsidieswhich are fiscally unsustainableanddistortinginput use. Savings shouldbe usedto fund more productive investments in agricultural research and extension, rural roads, and rural electrification. Reduce regulation of domestic trading activities for major agricultural commodities and eliminate remainingtradepolicy distortions,including subsidized exportsofrice andwheat. 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Polio News Eradication, Global Polio Eradication Initiative, Newsletter 11.17, December. World Health Organization. (1999). WorldHealth Report 1999: Making a Difference. Young, A. (1993). Land Degradation in South Asia: Its severity, causes, and effects upon the people. Final report prepared for submission to the Economic and Social Council of the UnitedNations (ECOSOC). Rome: Food and Agriculture Organization of the United Nations, United Nations Development Program, and UnitedNations Environment Program. 95 STATISTICAL ANNEX Table AI. Gross DomesticExpenditureand Product (Shares based on current price data, percent) 1993-94 1994-95 1995-96 1996-97 1997.98 1998-99 1999-00 2000-01 2oO1.02 A. Shares of gross domestic expenditure at market prices 1. Final consumption 78.3 76.3 75.3 76.7 75.8 77.7 78.6 77.7 77.9 a) Public Sector 11.4 10.7 10.8 10.7 11.3 12.3 13.0 13.1 12.8 b) Private 66.9 65.6 64.5 66.0 64.5 65.4 65.6 64.6 65.0 2. Gross capital formation 21.3 23.4 26.5 21.8 22.6 21.4 23.7 22.5 22.4 a) Gross fixed capital formation 21.4 21.9 24.4 22.8 21.7 21.5 21.8 21.8 21.7 i) Public sector 8.0 8.8 7.7 6.9 6.4 6.5 6.2 6.1 5.9 ii) Private sector 13.4 13.2 16.7 15.9 15.3 15.1 15.6 15.8 15.7 b) Change in inventories -0.2 1.4 2.2 -1.o 0.9 -0.1 1.9 0.7 0.8 3. Total Absorption (1+2) 99.5 99.7 101.8 98.5 98.4 99.1 102.3 100.2 100.3 4. Resource balance 0.0 -0.3 -1.2 -1.2 -1.3 -1.7 -2.0 -0.8 -0.7 a) Exports of goods & services 10.0 10.0 11.0 10.6 10.9 11.2 11.8 13.8 13.3 b) Imports of goods & services 10.0 10.3 12.2 11.8 12.1 12.9 13.7 14.5 13.9 5. Gross domestic product 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 6. Net income from abroad -1.4 -1.3 -1.I -1.o -0.9 -0.9 -0.8 -0.8 -0.6 7. Gross national income (54) 98.6 98.7 98.9 99.0 99.1 99.1 99.2 99.2 99.4 8. Net current transfers from abroad 1.9 2.5 2.4 3.2 2.9 2.5 2.7 2.8 2.5 9. Gross national disposable income (74) 100.5 101.2 101.3 102.3 102.0 101.6 101.9 102.0 102.0 10. National savings (9-1) 22.2 24.9 26.0 25.6 26.2 23.9 23.3 24.2 24.1 a) Public Sector 0.6 1.7 2.0 1.7 1.3 -1.o -1.o -2.3 -2.5 b) Private Sector 21.6 23.2 23.9 23.9 24.9 24.9 24.4 26.5 26.6 B. Sharesof GDP by IndustrialOrigin 1.Agriculture 28.2 27.5 25.5 26.5 25.4 25.4 23.9 22.7 22.8 2. Industry 23.9 24.5 25.4 24.9 24.9 24.3 23.5 24.2 23.6 Construction 4.7 4.6 4.6 4.6 5.1 5.3 5.4 5.5 5.5 Gas, electricity, water 2.2 2.4 2.3 2.2 2.3 2.5 2.2 2.2 2.2 Mining and quarrying 2.3 2.2 2.1 2.0 2.2 2.0 2.1 2.2 2.0 Manufacturing 14.6 15.3 16.3 16.1 15.2 14.5 13.8 14.3 13.9 3. Services 38.9 38.5 39.4 39.5 41.O 42.0 43.6 44.2 44.8 4. Statistical discrepancy -1.o 0.0 0.0 0.0 0.0 0.0 91.o 0.0 0.0 0.0 5. Total value added at basic prices 90.9 90.5 90.3 90.9 91.3 91.8 91.I 91.2 6. Taxes less subsidies on products 9.1 9.5 9.7 9.1 8.7 8.2 9.0 8.9 8.8 7. GDP at market prices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Memo Item (Rs. billion) Gross domestic product at market prices 8592 10128 11880 13682 15225 17409 19369 21043 22960 Source: Central Statistical Organization, National Accounts Statistics. 96 Table A2. Gross Domestic Expenditure and Product (Rs. billion at current prices) 1993-94 199495 1995.96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 A. GDP by Expenditure 1. Final consumption 6725 7728 8946 10494 11539 13534 15227 16353 17879 a) Public Sector 977 1086 1288 1457 1722 2140 2511 2759 2950 b) Private 5748 6642 7658 9037 9817 11394 12716 13594 14929 2. Gross capital formation 1826 2368 3152 2979 3437 3722 4583 4736 5151 a) Gross fixed capital formation 1843 2222 2894 3119 3304 3743 4219 4598 4973 i) Public sector 689 889 916 943 971 1123 1204 1277 1357 ii) Private sector 1154 1334 1978 2175 2333 2620 3015 3321 3616 b) Change in inventories -17 145 258 -140 133 -21 364 138 178 3. Total Absorption (1+2) 8551 10096 12098 13472 14976 17257 19809 21089 23030 4. Resource balance 1 -31 -142 -162 -191 -295 -380 -159 -158 a) Exports of goods & services 861 1016 1307 1449 1652 1953 2277 2902 3045 b) Imports of goods & services 860 1047 1450 1610 1843 2247 2657 3061 3202 5. Gross domestic product 8592 10128 11880 13682 15225 17409 19369 21043 22960 6. Net incomefrom abroad -121 -131 -135 -131 -132 -150 -154 -174 -127 7. Gross national income (54) 8471 9997 11745 13551 15093 17260 19215 20869 22834 8. Net current transfers from abroad 165 254 285 439 440 432 531 585 578 9. Gross national disposable income (74) 8637 10251 12030 13990 15533 17692 19746 21454 23412 10. National savings (9-1) 1912 2523 3084 3497 3994 4158 4519 5101 5533 a) Public Sector 54 168 241 229 203 -172 -200 480 -577 b) Private Sector 1857 2355 2843 3267 3792 4329 4720 5581 6110 B. GDP by Industryof Origin 1.Agriculture 2420 2788 3031 3626 3870 4425 4620 4785 5226 2. Industry 2052 2485 3018 3411 3785 4235 4557 5099 5417 Construction 406 466 550 628 778 920 1053 1166 1256 Gas, electricity, water 190 238 277 300 353 436 423 466 500 Mining and quarrying 201 227 253 277 334 357 413 454 463 Manufacturing 1255 1554 1938 2207 2320 2522 2668 3014 3199 3. Services 3342 3897 4684 5398 6246 7320 8443 9293 10297 Transportation 511 611 707 836 975 1125 1243 1403 1545 Trade 994 1192 1463 1717 1945 2208 2460 2727 3025 Dwellings 484 529 590 655 728 855 1015 1204 1370 Banking 417 501 661 720 840 956 1191 1185 1302 Public administration 436 486 573 652 800 996 1167 1240 1331 Other 500 577 690 817 958 1180 1367 1535 1726 4. Statistical discrepancy 0 0 0 0 0 0 0 0 0 5. Total value added at basic prices 7813 9171 10733 12435 13901 15981 17619 19177 20940 6. Taxes less subsidies on Droducts 779 957 1147 1247 1324 1429 1750 1866 2020 7. GDP at market prices 8592 10128 11880 13682 15225 17409 19369 21043 22960 Source; Central Statistical Organization,NationalAccounts Statistics. 97 Table A3. National Income and Product at constant prices (annual growth rates, in percent) 1994-95 1995-96 1996-97 1997-98 1998-99 1999.00 2000-01 2001-02 A. GDP by Expenditure and Income 1,Final consumption 4.2 6.5 7.4 3.8 7.4 7.1 2.3 6.1 a) Public Sector 1.2 8.0 4.5 11.1 12.9 13.2 0.6 7.2 b) Private 4.6 6.2 7.9 2.6 6.4 6.0 2.6 5.9 2. Gross capital formation 12.8 19.3 1.6 2.2 8.6 8.6 9.4 3.0 Gross fixed capital formation 11.8 19.3 1.5 2.1 8.7 8.6 4.7 3.0 i) Public sector 18.0 -6.5 -5.9 -2.8 9.4 4.9 10.9 3.0 ii) Private sector 8.1 36.1 4.8 4.1 8.4 10.0 2.4 3.0 3. Total Absorption 6.0 9.4 6.0 3.4 7.7 7.5 4.0 5.3 4. Exports of goods & services 13.1 31.4 6.3 -2.3 13.9 18.0 23.4 6.0 5. Imports of goods & services 22.7 28.0 -2.5 13.2 20.8 7.0 6.5 3.5 6. Capacity to Import 18.9 19.0 -2.7 12.8 17.2 5.5 17.8 3.8 7. Gross Domestic Incomeat market prices 8.0 6.4 6.3 6.3 6.4 5.5 3.0 5.1 8. Gross national income 7.4 7.8 7.7 4.5 5.9 7.2 3.9 5.8 9. Gross national disposable income 8.1 7.7 8.5 4.2 5.5 7.5 3.9 5.5 10.Gross national savings 21.8 11.4 11.6 5.6 0.5 8.5 8.7 4.0 B. GDP by Industrial origin 1,Agriculture 5.0 -0.9 9.6 -2.4 6.2 0.3 -0.4 5.7 2. Industry 10.2 11.6 7.1 4.3 3.7 4.8 6.6 3.3 Construction 5.5 6.2 2.1 10.2 6.2 8.0 6.9 3.7 Gas, electricity, water 9.4 6.8 5.4 7.9 7.0 5.2 5.0 4.3 Mining and quarrying 9.3 5.9 0.5 9.8 2.8 3.3 2.4 1.o Manufacturing 12.0 14.9 9.7 1.5 2.7 4.0 7.3 3.4 3. Services 7.1 10.5 7.2 9.8 8.4 10.1 5.6 6.8 4, Total value added at basic prices 7.3 7.3 7.8 4.8 6.5 6.1 4.4 5.6 5. GDP at market prices 7.5 7.6 7. 4 . . 4.5 6.0 7.1 3.9 5.5 Notes: 'I Exports deflated by importprice index. Source: Central Statistical Organization, NationalAccounts Statistics. 98 Table A4. Gross Domestic Product by Expenditure, National Income and Savings (Rs. billion at 1993-94 prices) 1993-94 1994.95 1995-96 1996-97 1997-98 1998.99 1999.00 2000-01 2001-02 A. GDP by Expenditureand Income 1. Final consumption 6725 7004 7458 8012 8313 8924 9561 9780 10378 a) Public Sector 977 989 1069 1116 1240 1400 1584 1593 1709 b) Private 5748 6015 6389 6896 7073 7524 7977 8186 8669 2. Gross capital formation 1826 2061 2458 2496 2551 2772 3010 3294 3394 a) Gross fixed capital formation 1843 2061 2458 2495 2548 2769 3008 3148 3244 i) Public sector 689 813 759 715 695 760 798 885 911 ii) Private sector 1154 1248 1698 1780 1853 2009 2210 2264 2333 b) Change in inventories 141 378 252 189 343 140 493 304 150 3. Total Absorption (1+2) 8551 9065 9916 10509 10864 11696 12571 13074 13772 4. Resource balance 1 -82 -71 43 -163 -290 -144 149 210 a) Exports of goods & services 861 974 1280 1361 1329 1514 1786 2204 2336 b) Imports of goods & services 860 1055 1351 1318 1492 1803 1930 2054 2125 5. Gross domestic product 8592 9233 9939 10674 11152 11820 12664 13163 13881 6. Trading gains or losses 50 -61 -175 8 53 -132 -256 -315 7. Gross domestic income (54) 85920 9284 9878 10499 11161 11874 12532 12907 13566 8. Net income from abroad -121 -132 -126 -107 -106 -120 -116 -124 -84 9. Gross national income (74) 8471 9101 9813 10567 11046 11700 12548 13039 13798 10. Net current transfers from abroad 165 232 238 339 322 293 345 362 345 11,Gross national disposable income (9+10) 8637 9333 10052 10906 11368 11994 12892 13401 14143 12.Gross national savings (11-1) 1912 2329 2594 2894 3056 3069 3332 3621 3765 Memo Item: Capacity to import 861 1024 1219 1185 1337 1567 1654 1948 2021 B. GDP by Industrialorigin 1,Agriculture 2420 2541 2519 2761 2694 2861 2870 2859 3021 2. Industry 2052 2261 2524 2702 2818 2923 3064 3266 3375 Construction 406 428 455 465 512 544 587 628 652 Gas, electricity, water 190 208 222 234 252 270 284 298 311 Mining and quarrying 201 220 233 234 257 264 273 279 282 Manufacturing 1255 1405 1614 1770 1797 1846 1920 2061 2131 3. Services 3342 3579 3953 4238 4654 5043 5551 5862 6259 Transportation 511 562 623 674 730 789 876 983 1066 Trade 994 1100 1259 1355 1458 1569 1682 1751 1906 Dwellings 484 499 527 550 580 613 659 719 761 Banking 417 452 501 550 648 705 800 790 816 Public administration 436 442 472 491 562 622 704 722 743 Other 500 525 571 617 676 744 829 897 966 4. Statistical discrepancy 0 0 0 0 0 0 0 0 0 5. Total value added at basic prices 7813 8380 8996 9701 10166 10827 11484 11987 12654 6. Taxes less subsidies on DrOdUCtS 779 853 944 974 987 993 1179 1177 1227 7. GDP at market prices (54) 8592 9233 9939 10674 11152 11820 12664 13163 13881 Source: Central Statistical Organization, National Accounts Statistics. 99 Table A5. Exchange Rates and Prices 1993.94 199495 1995-96 1996-97 1997.98 1998-99 1999.00 2000-01 200142 Exchange Rates (Rs. per US$) Nominal official average exchange rate 31.37 31.40 33.45 35.50 37.16 42.07 43.33 45.68 47.69 Real effective exchange rate (1985=100) 61.59 66.0 63.6 63.8 67.0 63.4 63.3 66.5 68.4 Price Indices Wholesale price index (1993-94=100) 100.0 112.5 121.6 127.2 132.8 140.7 145.3 155.7 161.3 Consumer Price Index (1993-94400) 100.0 107.6 118.3 129.4 138.3 156.4 161.6 168.0 173.1 CPI (YOchange) 5.0 7.6 10.0 9.4 6.8 13.1 3.3 3.9 3.1 Manuf. Exp. Unit Value Index (1990=100) 106.7 110.5 117.0 111.3 103.5 99.6 99.4 97.3 95.9 ImplicitDeflators (1993=100) Real gross domestic product 100.0 109.7 119.5 128.2 136.5 147.3 153.0 159.9 165.4 Exports of goods and services 100.0 95.9 97.9 93.9 80.4 77.5 78.4 75.9 76.7 Imports of goods and services 100.0 100.8 93.2 81.8 81.0 80.2 72.6 67.1 66.4 Terms of trade Index 100.0 95.1 105.0 114.8 99.4 96.6 108.0 113.1 115.6 Sources: IMF; Reserve Bank of India; GOI, Ministry of Industry; and World Bank. 100 w w w m m r -dr- m 9 m - w r-onlmLo W - o w N- f .-O d N - h l m m d m m 0.-m w m w 0r- N ON-- N.- 2 m o m m --mw ohlr- --r.ohl r - o w w m m o w 0 wm.-.-N 0 r- w m m o o m 0 m O b d W O L D m m m m hl 7.- cv) 1 m 0 .n 3 2 a s25 c R h J Table A12. Banking Survey and Interest Rates 1993-94 1994.95 1995.96 1996-97 1997.98 1998.99 1999-00 2000-01 200142 1. Banking Survey A) Billions of rupees- end year stock Net foreign assets 423 650 647 889 1109 1373 1663 1966 2603 Domestic credit 4375 5083 5929 6533 7434 8692 9942 11415 12819 Claims on public sector 2141 2344 2739 2952 3343 3877 4397 4986 5689 Claims on private sector 2110 2611 3057 3455 3945 4621 5319 6256 6974 Claims on non-bank fin. Institutions 124 128 133 126 147 193 226 174 156 Total assets (= total liabilities) 4798 5733 6576 7422 8543 10065 11605 13381 15422 Liquid liabilities 4798 5733 6577 7422 8543 10065 11605 13381 15422 olw Money +Quasimoney 4106 5025 5657 6578 7746 9122 10345 12077 13821 Money market instruments 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Long term foreign liabilities 0.0 0.0 0.0 0.0 0.0 13.7 12.9 13.5 0.0 All other net 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 B) Shares of GDP (%) Net foreign assets 4.9 6.4 5.4 6.5 7.3 7.9 8.6 9.3 11.3 Domestic credit 50.9 50.2 49.9 47.7 48.8 49.9 51.3 54.2 55.8 to public sector 24.9 23.1 23.1 216 22.0 22.3 22.7 23.7 24.8 to private sector 24.6 25.8 25.7 25.3 25.9 26.5 27.5 29.7 30.4 Liquid liabilities 55.8 56.6 55.4 54.2 56.1 57.8 59.9 63.6 67.2 Long term foreign liabilities 0.0 0.0 0.0 0.0 0.0 0.1 0.1 0.1 0.0 C) Real annual growth rates(%) Net foreign assets 43.0 -9.5 25.5 16.8 9.5 17.2 13.7 28.5 Domestic credit 8.0 6.1 0.7 6.5 3.4 10.7 10.5 9.0 to public sector 1.8 6.3 -1.5 6.0 2.5 9.8 9.1 10.7 to private sector 15.0 6.5 3.3 6.9 3.6 11.4 13.2 8.2 Liquid liabilities 11.1 4.3 3.1 7.7 4.1 11.6 11.0 11.8 Long term foreign liabilities -9.3 0.8 II.Interestrates (%) Money market rate (Call money rates) 6.99 9.4 17.7 7.8 8.7 7.8 8.9 9.2 7.3 Yield on GO1 Securities (1 to 5 years) 11.86-12.86 9.75-11.76 6.00-14.28 5.21-16.21 5.50-17.69 4.45-17.73 3.18-14.30 4.94-16.66 Deposit rate (1to 3 Years) 10 11.0 12.0 11.0-12.0 10.5-11.0 9.0-11.0 8.5-9.5 8.5-9.0 8.0-8,5 Lending rate (Minimum Lending Rate) 14 15.0 16.5 14.5-15.0 14 12.0-13.0 12.0-12.5 11.0-12.0 11.0-12.0 Real deposit rate * 5.0 3.4 2.0 1.6-2.6 3.74.2 4.1--2.1 5.2-6.2 4.6-5.1 4.9-5.4 Real lending rate * 9.0 7.4 6.5 5.1-5.6 14.0 -1.0 --0.1 8.7-9.2 7.1-8.1 7.9-8.9 Notes: Nominal rates less Inflation Sources: IFSand Reserve Bank of India. 107 Table A I 3.(US$ Balance of Payments Millions) 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000.01 2001-02 ~ CurrentAccount Exports of goods & services 27947 32990 39657 41607 45109 47484 53251 63764 65201 Exports of goods 22683 26855 32311 34133 35680 34298 37542 44894 44915 Exports of services 5264 6135 7346 7474 9429 13186 15709 18870 20286 Imports of goods & services 31468 41437 51213 55696 59297 58565 67028 75656 73705 Imports of goods, f.0.b. 26739 35904 43670 48948 51187 47544 55383 59264 57618 Imports of services 4729 5533 7543 6748 8110 11021 11645 16392 16087 Net trade in goods & services -3521 -8447 -11556 -14089 -14188 -11081 -13777 -11892 -8504 Income receipts 395 886 1429 1073 1561 1935 1931 2366 2749 Income payments 3665 4317 4634 4380 5082 5479 5490 6187 5403 Net income from abroad -3270 -3431 -3205 -3307 -3521 -3544 -3559 -3821 -2654 Private current transfer receipts 5287 8112 8539 12435 11875 10341 12290 12873 12192 Private current transfer payments 22 19 33 68 45 61 34 75 67 Net private current transfers 5265 8093 8506 12367 11830 10280 12256 12798 12125 Current Account Balance -1526 -3785 -6255 -5029 -5879 -4345 -5080 -2915 967 Capital & FinancialAccount Net official capital grants 368 416 345 410 379 307 382 336 384 Net total private investment inflows 4235 4807 4805 6153 5390 2412 5191 5102 5925 Net direct investment inflows 668 983 2057 2841 3562 2473 2165 2342 3905 Net portfolio investment inflows 3567 3824 2748 3312 1828 -61 3026 2760 2020 External Assistance, net 1901 1526 883 1109 907 820 901 427 1204 Commercial Borrowings, net 607 1030 1275 2848 3999 4362 313 4011 -1147 Rupee Debt Service -1053 -983 -952 -727 -767 -802 -711 -617 -519 NRI Deposits, net 1205 172 1103 3350 1125 960 1540 2317 2754 Other Capital 2800 2604 -2425 -1321 -643 508 3866 -2805 2189 Reserves, net change -8724 -4644 2936 -5818 -3893 -3829 -6142 -5830 -11757 (negative sign indicates increase) Other Series Foreign Exchange reserves (end of period, incl. 19254 25186 21687 26423 29367 32490 38036 42281 54106 gold) Reserves (as months of imports of goods and 7.3 7.3 5.1 5.7 5.9 6.7 6.8 6.7 8.8 services) GDP (b/'liionsof US$) 273.9 322.6 355.2 385.4 409.7 413.8 447.0 460.6 481.4 Source:ReserveBankof India. 108 Table A14. Exports and Imports (US$ million) 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999.00 2000-01 2001-02 A. EXPORTS AI. Exports (fob, US$) Total Primary Commodities 4916 5214 7257 8035 7687 6928 6524 7126 7065 Oil Meals 741 573 702 985 924 462 378 448 474 Marine Products 814 1126 1011 1129 1207 1038 1183 1396 1218 Ores and Minerals 888 988 1175 1172 1061 893 916 1155 1214 Other Primary commodities 2473 2527 4369 4749 4495 4535 4048 4127 4159 Manufactures 16657 20404 23747 24613 26547 25792 29714 34391 33241 Gems and Jewellery 3996 4500 5275 4753 5346 5929 7502 7384 7306 Readymade Garments 2586 3282 3676 3753 3876 4365 4765 5578 5004 Other Manufactures 10075 12622 14797 16107 17325 15497 17447 21429 20930 Total 22683 26855 32311 34133 35680 34298 37542 44894 44915 A.2 Exports (constant prices- 1993-94) Total Primary Commodities 4916 4907 7868 7694 6676 7904 7171 7877 8546 Oil Meals 741 579 687 770 685 633 490 453 493 Marine Products 814 935 922 1033 1030 994 1141 1231 1288 Ores and Minerals 888 1136 1386 1181 1043 910 1070 1104 1094 Other Primary commodities 2473 2258 4874 4711 3918 5367 4469 5090 5671 Manufactures 16657 20388 23207 27003 23891 21907 23988 38427 41061 Gems and Jewellery 3996 4339 5283 5622 5700 6452 7898 8857 8116 Readymade Garments 2586 2978 3285 4562 5711 6415 7090 8146 8637 Other Manufactures 10075 13071 14639 16819 12481 9040 9000 21424 24308 Total 22683 25769 33739 36290 34007 35638 40711 49681 52391 6.IMPORTS B.l Imports (cif, US$) Food 327 1144 970 1214 1483 2524 2417 1443 2044 Consumer Goods 3032 4249 5819 5115 5143 4307 4618 3722 4209 POL and Other Energy 5754 5928 7526 10036 8164 6399 12611 15650 14000 Intermediate Goods 7951 9696 12031 12845 16898 19094 21059 20780 21519 Pearls, Precious and Semi-precious 2635 1630 2106 2925 3342 3760 5436 4808 4622 Stones Organic and Inorganic Chemicals 1371 2137 2566 2661 2956 2684 2866 2444 2771 Other intermediate goods 3946 5929 7359 7260 10600 12650 12757 13528 14126 Capital Goods 6243 7638 10330 9922 9796 10064 8966 8941 9315 Total 23306 28654 36675 39132 41485 42389 49671 50536 51087 6.2 Imports (constant prices, 1993-94) Food 327 858 641 1002 1276 2085 1768 2078 1542 Consumer Goods 3032 3603 4606 3812 4171 3551 4133 3215 4202 POL and Other Energy 5754 5775 6832 7614 7793 8504 9533 9207 9978 Intermediate Goods 7951 4212 12073 13196 18108 22794 24873 25326 24709 Pearls, Precious and Semi-Precious 2635 1493 1550 2337 2875 3656 5518 4161 4600 Stones Organic and Inorganic Chemicals 1371 1898 2319 2784 2881 5986 7480 5419 2773 Other intermediate goods 3946 821 8204 8075 12352 13152 11875 15745 17337 Capital Goods 6243 14413 12286 10584 8438 8635 9559 9598 11091 Total 23306 28861 36438 36208 39786 45568 49865 49424 51523 C. INDEXES (1993=100) C1. Volume Indices Merchandise Exports 100.0 113.7 149.2 159.9 149.9 155.0 179.0 221.7 274.7 Merchandise Imports 100.0 124.1 156.4 155.5 170.8 195.7 214.2 212.1 210.0 C2. Price Indices Merchandise export price index 100.0 104.2 95.8 94.1 104.9 96.2 92.2 90.4 86 Merchandise import price index 100.0 99.3 100.7 108.1 104.3 93.0 99.6 102.3 99 Merchandise Terms of Trade 100.0 105.0 95.1 87.0 100.6 103.5 92.6 88.4 86 Source: ReserveBank of India. 110 Table A15 External Debt and Debt Service 1993-94 1994-95 1995-96 1996-97 1997.98 1998.99 1999.00 2000-01 2001-02 1. (millions of US dollars) A. Debt Outstanding and disbursed Total long term 85676 93907 87040 85427 88606 93021 94354 95971 94120 Public and pub. guaranteed 83906 87480 80422 78045 79398 84611 86410 83491 82446 Private non-guaranteed 1770 6427 6618 7382 9208 8409 7944 12480 11674 Short term 3626 4264 5049 6726 5046 4329 3933 3462 2951 IMF 5041 4312 2374 1313 664 288 26 0 0 Total DOD 94342 102483 94464 93466 94317 97637 98313 99433 97071 6. Debt Service Interest 4178 4633 4918 4364 4864 5120 3782 4182 3817 Amortizations 4033 5144 6929 6644 6936 6574 6062 6661 5465 IMF repurchases 134 1174 1719 972 613 390 262 25 0 Total 8345 10951 13566 11981 12413 12084 10107 10868 9282 II.Ratios(%) Total DOD to GDP 34.4 31.8 26.6 24.3 23.0 23.6 22.0 21.6 20.2 Total DOD (%total exports) 280.5 244.1 190.4 169.6 161.1 163.4 145.7 125.9 121.1 Debt service (% total exports) 24.8 26.1 27.3 21.7 21.2 20.2 15.0 13.8 11.6 Source:Global DevelopmentFinance,2003. 111 Table A16. Financial Sector Indicators 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 A. Banking System 1. Depth and Structure Total domestic credit (%of GDP) 47.7 48.8 49.9 51.3 54.2 55.8 of which private credit (% of GDP) 25.3 25.9 26.5 27.5 29.7 30.4 Number of banks Public Sector 27 27 27 27 27 27 Private Banks 30 Foreign Banks 23 2. Efficiency and Strength Spread over LIBOR 10.4 8.1 8.0 7.1 5.8 8.3 Non-performing loans as % of total Public sector banks(27) 17.8 16.0 15.9 14.0 12.4 11.1 Private banks (34) 8.5 8.7 10.8 8.2 8.4 9.7 Foreign banks (45) 4.3 6.4 7.6 7.0 6.8 5.4 B. Stock Market Market Capitalization (%GDP) 32.0 31.4 25.4 41.5 32.4 23.1 Value Traded (%GDP) 25.06 38.64 35.80 62.63 111.56 52.20 No. of listed companies 5795 S&P/IFC investable index (annual % change) -2.0 5.8 -23.0 81.O -31.I -19.9 Sources: RBI and World Development Indicators. 112 Table A17. Investment Climate Year India Income Group Regional Middle-Income Average Average Average Private Investment Environment Private InvestmentlGross Domestic Fixed Investment (%) 1995-1999 61.O 53.7 71.8 74.8 Domestic Credit to Private Sector (stock, % GDP) 2001 29.1 24.1 28.8 57.8 Real lending Rate 2001 Highest Marginal Corporate Tax Rate (%) 2002 36.0 Euromoney Credit Rating Sep-02 55.1 28.4 38.7 46.5 ICRG Composite Risk Rating Oct-02 65.8 58.8 69.5 69.8 Institutional Investor Risk Rating Sep-02 47.3 18.0 36.4 39.0 Governance ICRG Corruption Rating (1-6, bad to good) Feb-03 1.5 ICRG Bureaucratic Quality Rating (1 - 6) Feb-03 3.0 ICRG Law and Order (1 - 6) Feb-03 4.0 Openness Trade (imports+exports)/GDP (%) 2001 19.5 37.6 23.4 50.2 FDI inflows (% GDP) 2001 0.6 1.7 0.6 3.9 WTO member? Y Weighted Mean Tariff (%) 2001 28.2 Infrastructure Paved Roads, % of total 1995-2001 45.7 16.1 36.9 52.7 Motor vehicles (per 1000 persons) 2000 8 10 8 65 Cost of Calls to US (US$ per 3 min) 2001 4.20 3.60 Internet Users (thousands) 2001 5,000 9,337 5,413 87,311 Electricity consumption (kwh per capita) 2000 355 350 323 1,391 GDP per unit energy use (PPP $ per Kg oil equivalent) 1999 4.6 3.6 4.9 4.0 Wages and Productivity Minimum Wage (US$ per year) 1995-99 408 Labor Cost Per Worker in Manufacturing (US$ per year) 1995-99 1,192 Value Added Per Worker in Manufacturing (US$ per year) 1995-99 3,118 R&D Expenditure (% of GNI) 1989-2000 0.62 0.62 Source: World Bank, World Development Indicators Database,2003. 113 Table AI 8. Vulnerability Indicators 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 A. Market Indicators Annual percent change in average exchange rate (%) 6.1 4.7 13.2 3.0 5.4 4.4 Annual change in T-Bill rates (short-term) Average spread on Eurobonds (basis points) Annual change in stock market index (%) -2.0 5.8 -23.0 81.O -31.I -19.9 B. Risk Ratings ICRG composite (1-100,bad to good) 68.1 69.2 65.2 63.3 63.8 65.0 Euromoney (1-100, bad to good) Institutional Investor (1-100, bad to good) C. Financial Annual growth in real domestic credit (%) 0.7 6.5 3.4 10.7 10.5 9.0 Foreign currency to total deposits (%) 15.4 16.4 17.0 18.1 18.6 21.9 Non-perfm. loans of commercial banks (% of total) Public Sector 17.84 16.0 15.89 13.98 12.37 11.09 Private Banks 8.49 8.7 10.81 8.17 8.37 9.65 Foreign Banks 4.29 6.4 7.59 6.99 6.84 5.38 D. Reserve Cover Indicators Reserve cover of imports (months of imports) 5.7 5.94 6.7 6.8 6.7 8.8 Reserves to short term debt 3.9 5.8 7.5 9.7 12.2 18.3 ReserveslM2 (%) 12.2 13.2 13.7 14.8 15.3 18.0 E. Prices Annual change in terms of trade (%) -8.5 15.6 2.8 -10.5 -4.5 -2.2 Annual Depreciation REER (%) 0.3 5.0 -5.3 -0.2 5.1 2.9 F. External Current account balance (% of GDP) -1.3 -1.4 -1.o -1.1 -0.6 0.2 External Debt (% of GDP) 24.3 23.0 23.6 22.0 216 20.2 G. Fiscal sustainabilityindicators(General Govt.) Total Public Debt (% of GDP) 65.1 66.5 66.9 70.6 75.4 79.8 Fiscal Deficit (% of GDP) 6.4 6.7 9.3 9.7 9.6 11.0 Primary Deficit (% of GDP) 1.2 1.5 3.9 3.8 3.6 4.7 Sources: IFS,WDI, Reselve Bank of India and World Bank Staff Estimates. 114 Table A19. Millennium Development Goals Indicators 1990 1994 1999 2001 1. Eradicate extreme poverty and hunger 2015target halve 1990$1 a day poverty and malnutrition rates Population below $1 a day (%) 44 Poverty gap at $1a day (%) 12 Poverty rate (%) 36 28.6 Percentage share of income or consumption held by poorest 20% 8 Prevalence of child malnutrition (% of children under age 5) 64 53 47 Population below minimum level of dietary energy consumption (%) 25 23 2. Achieve universal primary education 2015 target net enrollment to 100 Net primary enrollment ratio (% of relevant age group) 51 77 Percentage of cohort reaching grade 5 (%) 55 ' 60 Youth literacy rate (% ages 15-24) 64 68 72 73 3. Promotegender equality 2005 target education ratio to 100 Ratio of girls to boys in primary and secondary education (%) 68 70 75 Ratio of young literate females to males (% ages 15-24) 74 78 81 81 Share of women employed in the nonagricultural sector (%) Proportion of seats held by women in national parliament (%) 8 48 4. Reduce child mortality 2015 target reduce 1990 under 5 mortality by two-thirds Under 5 mortality rate (per 1,000) 94 95 Infant mortality rate (per 1,000 live births) 79 68 Immunization, measles (% of children under 12 months) 35 42 5. Improve maternal health 2015 target reduce 1990 maternal mortality by three- fourths Maternal mortality ratio (per 100,000 live births) 424 540 Births attended by skilled health staff (% of total) 34 42 6. Combat HIVIAIDS, malaria and other diseases 2015 target halt, and begin to reverse, AIDS, etc. Prevalence of HIV, female (% ages 15-24) 0.6 Contraceptive prevalence rate (% of women ages 1549) 40.6 48.2 Number of children orphaned by HlVlAlDS Incidence of tuberculosis (per 100,000 people) 467 544 Tuberculosis cases detected under DOTS (%) 6 7. Ensure environmental sustainability 2015 target various (see notes) Forest area (% of total land area) 21.4 21.6 Nationally protected areas (% of total land area) 4.8 4.8 GDP per unit of energy use (PPP $ per kg oil equivalent) 3.3 4 4.7 C02 emissions (metric tons per capita) 0.8 1 1,I Access to an improved water source (% of population) 68 78 Access to improved sanitation (% of population) 21 31 Number of households with toilet facility (%) 30 36 Access to secure tenure (% of population) 8. Develop a Global Partnershipfor Development 2015 target = various (see notes) Youth unemployment rate (% of total labor force ages 15-29) 10.1 12.1 Fixed line and mobile telephones (per 1,000 people) 5.9 13 26.5 32 Personal computers (per 1,000 people) 0.3 1.3 3.3 4.5 Note: Insome cases the data are for earlier or later years than those stated Source: World Development Indicators database, April 2003; National Family Health Survey (NFHS); National Sample Survey (NSS); Planning Commission, Govemment of India 115 Table A20: Development Indicators India and Comparator Countries - Indicator Unit Year India China Brazil Indonesia Pakistan Per Capita Income US$ 2000 450 840 3580 570 440 PPP Per capita income US$ 2000 2340 3920 7300 1860 Population Million 2000 1016 1262 170 138 Male literacy rate Percent 2001 76 92 85 57 Female literacy rate Percent 2001 54.3 76 85 28 Population below the poverty line Percent Survey year 26.1 (2000) 6(1996) 17.4(1990) 34 (1991) [I1 in brackets Population below US$l/day Percent Survey year 44.2 (1997) 31 (1996) in brackets Number of poor Million I99912000 312.6 75.7 29.6 47 Infant mortality rate Per 1000 2000 69 32 32 83 live births Life expectancy at birth Years 2000 63 70 68 63 Access to improved sanitation Percent 2000 31 38 77 61 facilities I21 Notes: Data on Maleand Femaleliteracyrate for countries other than India is for the year 2000 Source: World DevelopmentIndicators,2002, The World Bank; Poverty data on India(199912000) sourcedfrom PlanningCommission,Go1 Memo Items [I] an alternate methodologyused by Deatonand Dreze estimatedthe poverty headcountto be 28.6% in 199912000 [2] Access to improvedsanitationfacilities refersto % of populationwith at least adequateexcreta disposalfacilities (private orshared, but not public)that can effectively preventcontactwith excreta 116 Table A21:Unemployment Rates: Alternative Measures Unemployment Usual Usual Current Current Daily rates Principal Principal and Weekly Status Status Subsidiary Status Status (UPS) (UPSS) (CWS) CDS) All India 1987-88 3.8 2.6 4.8 6.1 1993-94 2.6 1.9 3.6 6.0 1999-00 2.8 2.2 4.4 7.3 Urban 1987-88 6.6 5.3 7.1 9.4 1993-94 5.2 4.5 5.8 7.4 1999-00 5.2 4.6 5.9 7.7 Rural 1987-88 3.1 2.0 4.2 5.3 1993-94 1.8 1.2 3.0 5.6 1999-00 2.0 1.4 3.9 7.2 117