India: a new tiger on the block?

Author:Panagariya, Arvind
Position:Contemporary Issues in World Trade

After three decades of inward-oriented development, India has made a decisive switch in its trade and foreign investment policies. Beginning in July 1991, the country systematically liberalized its economy. Though the pace of the reform may appear gradual to observers of Eastern Europe, the changes of the last three years evoke disbelief when viewed in the context of India's own past. Prior to 1991, a complex maze of quantitative restrictions, foreign-exchange controls and tariff rates averaging well over 120 percent (and rising as high as 400 percent) characterized trade policy. Today, virtually all import quotas except those on consumer goods and a few intermediate inputs and capital goods are gone, the rupee is convertible on the current account, and tariff rates are capped at 65 percent. Equally important, the P.V. Narasimha Rao government shows no signs of looking back, the government has continued on its progressive track presenting major changes with every budget since the beginning of the reform program.

India is not only the most populated democracy in the world, it is also one of the few developing countries that has functioned as a true democracy for more than four decades. This fact makes India's experience with economic reform unique. Unlike authoritarian states, a democratic government must mobilize public opinion in favor of new policies. Major policy changes face formidable challenges from entrenched interests even in advanced democracies such as the United States, as was demonstrated during the fierce debate on the North American Free Trade Agreement. In India, a developing country, this challenge from entrenched interests is even bigger and was partially responsible for the delay in the implementation of major reforms.

The central purpose of this paper is to analyze India's trade reform in the last three years. I look at all the major changes that have occurred, study their impact, evaluate the management of the reform and make suggestions for future policy changes. In pursuit of the last objective, I draw upon the recent experience of China.

A full understanding of the current reform process requires the knowledge of past trade policies and the policy regime the Rao government inherited. Therefore, in section one, the paper reviews the evolution of trade policy up to June 1991. In section two, I describe trade reforms undertaken since July 1991. A few of these reforms were made only recently, in February 1994 with the 1994-95 budget and in March 1994 with annual modifications to the Export-Import Policy 1992-97. The third section assesses the impact of the reform, particularly the impact on public opinion. The fourth section evaluates critically the management of reform, and asks questions such as whether the pace of the reform is too slow and whether the exchange rate has been satisfactorily managed. Finally, I offer suggestions for future trade reforms.

It should be noted at the outset that policy changes introduced in the last three years extend far beyond the external sector. The scope of this paper, however, is limited to the external sector. The paper refers to domestic regulatory controls only when they bear on foreign trade.(2)


Several factors combined to create and perpetuate the complex regime of import controls inherited by the present government. First, when India initiated its development program in the 1950s, the Soviet Union was regarded as a success story and the model to follow. Based on that experience, economists and policy makers were nearly unanimous in their opinion that, in a poor country, planning was essential to allocate the economy's resources efficiently. Without much hesitation, India chose the path of planned development. Although this strategy did help catalyze the process of growth in the long run, it also created an economic machinery and developed a mindset that were naturally receptive to controls.

Second, India's policy makers were deeply influenced by the prevailing ethos of export pessimism. They believed that because the demand for developing-country exports was relatively inelastic, India could not expect to expand its foreign exchange earnings dramatically. The natural course was to use the available foreign exchange prudently. This, in turn, meant allocating the scarce foreign exchange in accordance with priorities set by Five Year Plans.

Third, India had inherited an extremely proficient bureaucracy from the British. The top layer of the bureaucracy consisted of India's most talented individuals. Therefore, when controls began to be introduced, their implementation proved to be no challenge. Policy makers proposed and bureaucrats disposed. But over time, as the economy grew bigger and more complex, the determination of priorities across sectors and subsectors became a Herculean task. Bureaucrats, who had come to enjoy the power concomitant with the authority to implement controls, did not hesitate to exploit the situation. They themselves became active players in negotiating priorities for the allocation of resources. Arbitrariness and, eventually, bribes followed as natural consequences.

Fourth, once in place, import controls served the interests of both politicians and industrialists who had flourished behind the wall of protection. For the usual reasons, protection was popular in India: It protected domestic interests against foreign competition and, by keeping luxuries out of reach, also curbed conspicuous consumption. For their part, industrialists contributed generously to election campaigns to ensure the protection of their interests. Interestingly, partial trade liberalization, begun in the late 1970s, initially was intended to promote the interests of the industrialists. The philosophy behind this phase, articulated in the Alexander Committee Report of the Government of India (1978), was to improve access to noncompeting foreign inputs. The committee was explicit in noting that the goods to be liberalized should be those neither produced nor likely to be produced in India in the next three years.

Fifth, broadly speaking, India's economists in and out of government did not play the traditional role of the economist in challenging protectionist policies. Indeed, with rare exceptions, economists in India actively supported the government's import-substitution policies. By the early 1970s, evidence against export pessimism from countries in East Asia -- particularly from Hong Kong and Korea -- was loud and clear. But an intellectual movement in favor of outward-oriented polices never took root in India. It was only after the recent success of outward-oriented policies in China, a country more populous than India, that Indian economists began to doubt their protectionist convictions.(4)

Finally, in 1950s, the international trade and monetary system was far more tolerant of quantitative restrictions on imports and exchange controls than today. The exchange-rate system, introduced in 1945 under the auspices of the International Monetary Fund, required countries to maintain a fixed parity between their currencies and the U.S. dollar or pound sterling. Home currency was to be devalued or revalued only in the case of persistent deficits or surpluses, respectively. In practice, however, countries were resistent to any adjustment in the parity. Instead, taking advantage of the provisions of the General Agreement on Tariffs and Trade (GATT), they resorted to import restrictions to deal with short-term balance-of-payments deficits. Unfortunately, there was no automatic mechanism for the removal of quotas once the balance-of-payments crisis was over. Therefore, once introduced, import controls assumed the potential for becoming entrenched. It is ironic that the same foreign exchange crisis that under today's changed environment has resulted in the liberalization of import controls, led to the tightening of controls in the earlier years.

The machinery for import controls in India existed since May 1940, when the British government first introduced it. At that time, the objective behind the controls was to alleviate shortages of foreign exchange and shipping created by the Second World War. After the war, import policy alternated between liberalization and tighter controls. In 1951, a few years after independence, India launched its First Five Year Plan, with increased liberalization broadly characterizing the five years of this period.

During the 1956-57 fiscal year, India faced a foreign-exchange crisis, and the government's natural reaction was to resort to import controls.(5) Once introduced, however, the controls did not go away. On the contrary, they quickly became a part of the overall planning framework and were extended with time. By the early 1960s, the regime of controls was firmly in place, with virtually all uses of foreign exchange requiring administrative approval. Tariff rates also rose to levels that were quite high by international standards.

During the 1960s and 1970s, protection against foreign competition became an integral part of the government's strategy to achieve self-reliance. The existence of an eager and proficient civil service reinforced the prevailing view -- one shared by the country's policy makers and economists -- that priority sectors had to be protected and offered adequate access to foreign exchange. But, it was unclear how the priority sectors were to be selected.(6) The result was the creation of a regime dominated by bureaucratic discretion. Over time, as the industrial structure grew more diverse, so did the structure of foreign trade and regulations needed to govern it.

Starting in the late 1970s, several factors combined to create a phase of partial liberalization. First, by the mid-1970s, extremely poor economic performance created doubts among policy makers about the efficacy of the controlled regime. Second, pressures for better access to foreign inputs...

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