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8/9/2019 EEP-Why Policy and Antecedents of Economic Reforms-2015
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Economic Environment andPolicy
What is the course
about?
EEP-Antecedents to Economic Reform 1
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The Focus Provide an understanding of the emerging
economic and policy environment in India The discussion essentially covers the post-reform
(1991) period The antecedents of economic reform provide the
contet to the policy analysis Trace changes in different policy domains in the
post-1991 period and identify emerging policychallenges
The coverage of policies is not comprehensiveenough!!
EEP-Antecedents to Economic Reform "
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Broad Approach Indian situation analy#ed in the contet of
$onceptual underpinnings of mar%et and government(regulatory) failures
Eperience of East Asian economies (&here feasi'le)
egin &ith the analysis of the 199-91 crisis toeplore earlier conditions and policy paradigms Identify %ey policy distortions in different policy domains *iscuss changes envisaged in each policy domain and the
associated issues and challenges Eplore through the course ho& these distortions
have 'een addressed in the post 1991 period andho& a fe& ne& ones may 'e emerging
EEP-Antecedents to Economic Reform +
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A Caveat India is a comple economy, society and polity The compleity is significantly higher as the nation is large
and diverse and &ent (going) through five transformationssimultaneously (uha, "11) .ational (colony to an independent state) *emocratic (political participation of &omen, castes/) Industrial (movement a&ay from agriculture) 0r'ani#ation (villages to to&ns) ocial (rights of su'ordinate groups)
2ost other economies &ent through these transformationssequentially (0, Europe, $hina/)
The course focuses largely on the 3economic4 dimensionsand therefore remains inade5uate to provide a 3complete4picture
EEP-Antecedents to Economic Reform 6
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Why Regulate?Market Failures
Regulation
Introducing Key Concepts and Providing the Context for Policy
Intervention
EEP-Antecedents to Economic Reform 7
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EEP-Antecedents to Economic Reform 8
Why regulate and ho!? 2ar%et failures (discussed in Economic Analysis)
need to 'e corrected through regulation and policyintervention to enhance social &elfare
Endo&ment failures (another type o mar%et failure)
may also re5uire state intervention ut there can 'e government and regulatory
failures as &ell resulting in a variety of distortions Policy challenge ho& to regulate to avoid 'oth
%inds of failures:
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EEP-Antecedents to Economic Reform ;
Market Failure "ccurs i# 2ar%ets, especially future mar%ets, do not eist
Imperfections in access to information Information asymmetry Imperfections in foresight a'out the future Eternalities - positive or negative (private and social
costs
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EEP-Antecedents to Economic Reform @
Regulation$ Response tomarket #ailure or regulatorycapture? Regulation a response to pu'lic (consumer:) demand inthe presence of mar%et failures: Industries regulated in the a'sence of mar%et failures and firms
support ?hy: Regulation a response to industry4s demand (capture of
legislators): Industry (regulated) captures the regulatory agency (capture of
regulators) ut some regulations not supported 'y industry> ?hy:
oth types of empirical situations eist Regulation supplied in response to the demands of interest
groups acting to maimi#e utility
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EEP-Antecedents to Economic Reform 9
Endo!ment Failure AnotherType o# Market Failure? $onventional perspective is restrictive as
endo&ment failures can 'e critical Efficiency (maimi#ation of surplus) vs> e5uality
Etant distri'ution of endo&ments important 'ut ignored
in neo-classical perspective ?ho gets property rights: (Role of policy:) *istri'ution of surplus 'et&een 3consumers4 and
3producers4 important for policy (dynamic efficiency) 2ar%et errors commission omission
*istort mar%ets perpetuate crisis 2a%e participation in mar%ets disadvantageous for certain
sections through terms of trade shifts Reduction in &age-food price ratio during droughts is often
accompanied 'y no or slo& rene&al
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EEP-Antecedents to Economic Reform 1
A %i&erent Perspective''' 2ar%et errors commission omission>>
.ot create conditions (endo&ments) that ma%e mar%ettransactions advantageous
Perpetuate regular deprivation due to a'sence static efficiency 2aimi#ation of surpluses over time
Role of eternalities = investments in endo&ments andincentives for savings and investment = are important *istri'ution of surplus Endogenous gro&th theories emphasi#e on the role of
human capital in increasing returns to investment
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EEP-Antecedents to Economic Reform 11
Market Failures and
Regulation$ CurrentConsensus oth government mar%et failures eist
$hoice not 'et&een mar%ets or intervention 'ut 5uality ofintervention ?hen, &here and ho& to intervene:*isciplining function of mar%et competition useful forlearning and efficiency
Performance of mar%ets can 'e improved through a varietyof regulations including appropriate legal and property rightsystems
overnment may lac% capacity or coherence forappropriate action
Biscal pressures and informational pro'lems Crgani#ational vacuum in the government often does not
provide the re5uisite autonomy incentives Regulatory capture possi'ilities eist $ompetition among interest groups may vitiate policy
choices
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EEP-Antecedents to Economic Reform 1"
The Conte(t o#
Economic Re#orms in)ndia
Short, Medium & Long Term Dimensions ofthe Economic Crisis in 1991 and the ocus
of Structural !eform
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EEP-Antecedents to Economic Reform 1+
Immediate Manifestations ofthe Crisis evere 'alance of payments (oP) pro'lems
Do& fore reserves (only enough for t&o &ee%s) .ear 'an%ruptcy to service eternal de't
igh rates of inflation
1+-16F Gan-GunH91 In late 19@s inflation &as high despite no eternalshoc%s (unli%e oil shoc% of 19;9-@1) Inade5uacy of food stoc%
*iverse eplanations of the crisis 'ut t&o stoodout and &ere acted upon Di'erali#ation of the 19@s, eternal shoc%s and financial
mismanagement &ere maor contri'utors in the shortand medium term
The %ey pro'lems related to long term policy distortions&hich re5uired structural reform
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EEP-Antecedents to Economic Reform 16
Short-term Dimensions of theCrisis (1989-91)
?orsening CP situation - Increase incurrent account deficits due to Do&ering trade 'alance (ro&th of imports
greater than that of eports in 199-91) Do&er inflo& of remittances (Invisi'les)
urpluses in invisi'le a
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EEP-Antecedents to Economic Reform 17
Short-Term Dimensions ofthe Crisis (1989-91)...
oP Pressures got intensified 'y ulf ?ar (Ball in remittances, increase in oil prices, maor
epense in rescue operations in the ulf) ?idening fiscal deficits spilled into higher prices and imports
and a drain on fore reserves *o&ngrading of IndiaHs credit rating
hort-Term E$s (1@ *ays) 'ecame un-availa'le to rollovershort-term de't due this do&n-grade
*ecline in investors confidence led to an outflo& of .on-resident Indian (.RI) deposits
Increase in rates of inflation after the ulf crisis (J17F insecond half of 1991) compounded oP pro'lems
A 17F appreciation of rupee during 19;9-@1 &hich hadadverse impact on eports Bore rate got corrected in 19@8 'ut &as pro'a'ly too late
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EEP-Antecedents to Economic Reform 18
Medium-Term Dimensions Developments in the 1980s
Patterns of Industrial Production Impressive gro&th in industrial production (@>7F) ro&th of consumer dura'les faster than consumer non-
dura'les and intermediates Import intensity of these goods &as high leading to fore outgo *emand for oil, fertili#er and defense added to import needs
tagnancy in indigenous oil production also led to more PCDimports Cil shoc% of 19;9-@1 added to the adverse impact
Eport orientation led to epansion of eports in import-
intensive areas leading to higher imports ro&th of Industrial production led 'y dura'les had a
narro& 'ase &ith limited eternalities The rich constituted the Khome mar%et4 &hich &as not
sustaina'le
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EEP-Antecedents to Economic Reform 1;
Medium-Term Dimensions Developments in the
1980s…. Biscal Profligacy igh fiscal, revenue and moneti#ed deficits led to
increases in money supply and inflation *eficits also spilled into oP crisis
overnment reversed the policy of ensuring surplus in
revenue account to finance productive capital accountdeficit $apital a
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EEP-Antecedents to Economic Reform 19
Long-Term Dimensions Rethinking Development
Strategies 2aor long-term pro'lem &as a relatively lo& gro&thof national income (+>7 - 7F) Inade5uacy of savings for financing planned
investments - ecessive reliance on 'udgetaryresources led to large deficits
roadly, five types of pro'lems are identified Relative neglect of agriculture and rural development that
inhi'ited the gro&th of home mar%et *evelopment of inefficient, high cost, un-competitive
industrial structure erious infrastructure (transport, telecom, po&er, petroleum
products scarce) and human capital 'ottlenec%s ignificant financial capital constraints Eternal shoc%s
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EEP-Antecedents to Economic Reform "
How to orret these fai!ures" Argument for Reforms
Larious policies contri'uted to these failures 'yintroducing micro-economic rigidities &hichresulted in several distortions
If these rigidities did not eist performance &ould
have 'een 'etter Rigidities did not allo& firms to ma%e rational
choices Policy reforms re5uired to reduce
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EEP-Antecedents to Economic Reform "1
rigidities that
structural re#ormsaim to correct?
" Summary #These rigidities got $uilt o%er the years
ith the implementation of %arious policies'Many policies #e'g', those relating to e(it,la$our and agriculture) not included here'
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EEP-Antecedents to Economic Reform ""
Industria! #o!i$ %ased&igidities
Policy did not encourage competition and contri'uted toinefficiencies through ureaucratic determination of plant capacity, product mi and
location through licensing regime 2ar%et forces more or less ignored (lac% of contesta'ility)
evere entry and eit 'arriers &ith licensing and other controls(e>g>, 2onopoly Restrictive Trade Practices Act - 2RTPA) Rent-see%ing through and lo''ying for licenses for capacities and
scarce materials as their ac5uisition provided monopoly po&er Trade in scarce materials 'ecame more lucrative than efficient
manufacturing (no 3contests4, or 3stic%4)
Pronounced pro-la'our stance restricted &or%force rationali#ation u'sidi#ed ailing small scale industry (I) Employment vs> efficiency politically employment concerns critical Policy needs to enhance eport contri'ution of I ignored
Inhi'ited economies of scale through licensing and reservation forI (certain sectors reserved for the small firms)
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EEP-Antecedents to Economic Reform "+
THE INDUSTRIAL CONTROL SYSTEM
The establishment and operation of an industrial enterprise in India has required
approval from the Central Government at almost every step. Before making an
investment, an entrepreneur has to obtain approval in principle from the Ministry of Industry. The granting of this approval results in the issuance of a etter of Intent
!"I#. $rmed %ith this "I, the entrepreneur can then tie up other requirements for
setting up the pro&ect. If he needs to import a capital good, he must obtain a capital
goods import license from the Chief Controller of Imports ' ()ports !CCI'(#, in the
Ministry of Commerce. The approval for the import, ho%ever, is given by a committee
set up in the Ministry of Industry. If there is also a need for a foreign collaboration
agreement, the entrepreneur has to obtain a specific approval for this, an *.C. approval,
from a committee chaired by the *inance +ecretary, but serviced by the Ministry of
Industry. In order to raise funds for the pro&ect, if an entrepreneur %ants to go to the
capital market, he needs separate approval from the Controller of Capital Issues in the
Ministry of *inance. *or imports of ra% material and components, separate licenses
have to be obtained on an annual basis from the CCI'(. In each case, an essentiality
and indigenous nonavailability clearance has to be given by the technical %ing of the
Ministry of Industry, the irectorate General of Technical evelopment. "nce
everything is tied up and the unit is about to go into production, the entrepreneur has to
go back to the Ministry of Industry for an Industrial icense. !Mohan and $ggar%al,
-/#
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EEP-Antecedents to Economic Reform "6
Trade #o!i$ %ased
&igidities igh import tariffs meant lo& imports 'ased competition An anti-eport 'ias &hich 'lunted eport rivalry and the
associated spillover 'enefits from eports This 'ias &as reinforced 'y
$ur'ed imports via tariffs and 5uantitative controls as a part of
import-su'stitution strategy> This led to reduction in eternalcompetitive pressures and increases in input costs, especially ofeporta'les
Boreign echange policy &ith over-valued rupee made Indianeports non-competitive
lac% (*aala) mar%et emerged (0 M 7 'illion transactions
estimated for 199) and capital flight too% place (a'out Rs",8, crores stashed a&ay 'y Indians in &iss an%s!) Rent see%ing possi'ilities &ere high &ith multiple tariff rates,
5uotas and comple eemptions Inverted tariff structures (lo&er tariffs on final products and higher
tariffs on inputs) created 'iases against local production as &ell as
eports
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EEP-Antecedents to Economic Reform "7
#u'!i Setor #o!i$ %ased&igidities
Pervasiveness of the pu'lic sector in heavy industryand infrastructure Reservation for the pu'lic sector created entry 'arriers Inefficiencies in P0s led to higher input costs &ith significant
adverse effects for the rest of the economy through a variety
of input-output lin%ages Infrastructure 'ottlenec%s &ere particularly severe
Inefficiencies along &ith soft 'udget constraints meantlo& rates of return and no surpluses for reinvestment
Provided monopoly po&er to P0s in industries &hich
&ere reserved .o incentives or pressures to 'e efficient ?ith significant trade 'arriers these inefficiencies got
transmitted to other firms and sectors (esp> non-trada'les)
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EEP-Antecedents to Economic Reform "8
oreign Inestment #o!i$%ased &igidities
evere restrictions on portfolio and direct investment ectors of entry as &ell as etent of e5uity controlled .o threat of potential foreign competition Potential of technology flo&s through B*I restricted
Tight controls on technology transfer, licensing,international mar%eting ('rand) etc> Dicense fees, royalty rates and sectors &here foreign
technology can 'e licensed &as controlled
$ontrols on foreign technology 'ased entry 'y local producers
reduced these competitive pressures too Internationally efficient scales of production could not
'e achieved
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EEP-Antecedents to Economic Reform ";
inania! Setor #o!i$ %ased&igidities
$ompared to industrial sic%ness, financial sector sic%ness has amore severe impact through the multiplier effects, &hich aremore &idespread for the latter
$apital constraints 'y Ncro&ding outN of private sector anddiminished 'an% profits 'y Administered interest rates (mar%et forces ignored)
*irected NPolicy DoansN to agriculture and small industry (O 6Fof deposits) and government (DR O +8F of deposits) ureaucrat determined pricing in securities mar%et The amount of money that could 'e raised from the e5uity mar%et
&as also decided 'y the government Interestingly, many policies adopted 'y India &ere similar to
those used in East Asia 'ut could not ensure contesta'ility andavoid rent see%ing
The ne economic policy #+E) post 1991 as e(pected toremo%e these and other micro-economic rigidities so that firmscould ma.e rational choices #crisis as not only a short term phenomenon, the roots lay in long term)