15.227B Special Seminar in International Management-India-Spring 2004

Jerome Poupon, MBA, Class of 2005

May 2004

Aroun Shurie and the privatization of India’s economy

Three decades of closed economy

From 1950 to 1980, India’s development strategy came to be known as Nehruvian socialism. The aim was to develop a national industrial base and to achieve economic self-sufficiency.

Nationalization

Under this strategy, the state controlled the most influential sectors through the proliferation of large scale public enterprises. Some 70% of the work force was employed by the state, and the trade unions became extremely powerful. State workers resisted productivity improvements, and technological or structural change which might undermine their job security. The government continued to defend the state enterprises even though they grew increasingly inefficient, many incurring losses. This was an important reason for the low 3.5% per year average for GDP growth between 1950 and 1980.

Heavy agricultural subsidies

Overall, the government faced two conflicting objectives: to subsidize the urban population with cheap food and at the same time provide sufficiently high prices to guarantee farmers’ revenues.

The first objective was achieved at the expense of the second: the bias was in favor of the urban population, penalizing farmers. Agricultural prices were kept below world market levels in order to supply food at an affordable rate to people in the towns and cities. In an attempt to compensate farmers, the government heavily subsidized the agricultural sector, but not enough to overcome the bias.

Very high trade barriers

Industrial prices were kept high by trade barriers erected to obstruct imports. These included a system of import licenses designed to shield domestic manufacturers against competition from abroad. As a negative consequence, much-needed industrial spare parts were not available for industrial production. Protecting domestic producers meant exporters suffered, and so India’s share of world trade declined steadily from 2.5% in 1938, to 0.5% in the 1980s.

A continuous deterioration of the economic competitiveness

The extensive use of agricultural subsidies and industrial licenses prevented the efficient allocation of resources via market forces and foreign competition.

Under the system of government licensing, the private sector was stifled by restrictions which led to oligopolistic and uncompetitive practices, inefficiency, misallocation of resources and corruption.

Agriculture suffered from a series of severe droughts in the 1960s. The economic situation was made worse by the withdrawal of foreign aid in the 1970s.

The 1980s: deterioration of the economic situation

All through the 1980s, there was growing support for increased liberalization. For example, attempts to liberalize the economy were made by the Janata Party as early as 1977 and at the beginning of Rajiv Gandhi’s administration in 1984 (as the state started borrowing from the World Bank). The Janata government fell after reducing some industrial and import controls, and Rajiv Gandhi’s administration quickly became mired in scandal and lost the power to override party members who enjoyed the benefits of control. In all cases, resistance from powerful interest groups (bureaucrats, politicians and industrialists) and the lack of strong political leadership meant that little was done.

Throughout the decade, central government borrowing exceeded 5% of GDP as public expenditure grew faster than revenue. The problem was aggravated by subsidies, which reached 12% of GDP in 1990.

The gap between savings and investment widened, along with the budget deficit. The Gulf crisis triggered confidence crisis, and entailed capital flight, and a virtual cessation of foreign lending.

In 1991, the economy was on the verge of bankruptcy, with only two weeks worth of foreign exchange reserves and a current account deficit of 3% of GDP.

1990 reforms

The crisis was resolved with financial assistance from the IMF, which lent approximately $2.3bn between 1991 and 1993. The conditions of the loans included fiscal correction and trade liberalization.

In July 1991, Manmohan Singh’s government embarked on a liberalization policy, which was actually more radical than what was required by the IMF. The reformers took advantage of the macroeconomic crisis to push through some major changes which had long been resisted. They aimed at curbing trade deficits, by attracting foreign direct investment and increasing exports. Increasing export would allow earning foreign currency, which in turn could be used for paying for energy (India is a net importer of natural gas and oil), investment goods and imports in general. It would also allow servicing the debts and becoming competitive internationally.

Despite their slow pace, the cumulative reforms since 1991 have been substantial. The reforms can be summarized as follows.

  • Progressively more sectors were opened to private investment, including power, steel, oil refining and exploration, road construction, air transport, telecom, ports, mining, pharmaceuticals and the finance sector. Sectors such as garments and textiles that were previously reserved for small-scale industries were also delicensed.
  • Policymakers sought to encourage FDI with majority equity (except in a few “strategic” sectors, among which defense, nuclear energy, railways) and portfolio investment. Red tape was significantly reduced.
  • Most industries were delicensed to encourage competition.
  • Trade policy was liberalized. Some imports quotas were converted into tariffs, and the tariffs system was simplified to reduce the number of bands and achieve a reduction in overall rates imposed. From April 2001 remaining quotas on imports were removed, although tariffs remain high.
  • Some aspects of business decision making, such as the location of new enterprises and technology transfer were taken out of the state’s control. (Labor relations and the shutting down of loss-making enterprises remains strictly regulated).
  • The exchange-rate regime was liberalized, with the devaluation of the rupee by 22% against the US dollar in two installments in July 1991. A market determined exchange rate was introduced in March 1993, and current account convertibility began in August 1994. Since July 1995, all official foreign debt service payments have been channeled through the interbank market. However the rupee is not yet fully convertible on the capital account.
  • Capital markets were reformed. Private mutual funds, foreign institutional investors and country funds are active investors, and the stock market is subject to more rigorous regulation, although scandals every couple of years suggests there is still some way to go. Officials are pointing to the National Stock Exchange as the model market.

As central controls have receded, states have acquired more freedom to maneuver. Some states, such as Andhra Pradesh, Karnataka and Maharashtra, have shown considerable initiative in raising additional finance, including issuing bonds and encouraging private investment in irrigation, roads, bridges, software development, and agricultural projects. However, most states have made little progress. During 1997/98, 16 states resorted to overdrafts with the Reserve Bank of India; three of them had payments on their behalf halted when they failed to clear their accounts. In 1999, there was a radical change of policy and overdrafts were linked to economic reforms, including pricing reforms and disinvestment.

A mixed result

A result of the reforms, the recovery in foreign exchange reserves has been particularly marked. During the 1991 balance of payments crisis, India’s foreign exchange reserves had fallen to an all time low of $1bn. By the end of 1996, with increasing capital flows foreign exchange reserves rose to $20bn.

The reforms have allowed a spectacular growth over the last years, and the rapid burgeoning of a new middle class (300 millions people). However, the reforms have also resulted in some pain in certain sectors of the economy.

Not everyone has benefited from the reforms. In particular, liberalization has led to significant increases in the prices of fertilizers, rice, sugar, cotton and gasoline. Further inflation and increases in the prices of key agricultural commodities have accentuated fears that the reforms have raised the costs of living for the poor, especially the small farmers and urban workers.

More to come?

Still, the liberalization process is far from over. The IMF advocates further reforms, such as the removal of quotas and export licensing controls, and privatizing remaining state enterprises. Investment is needed to provide adequate infrastructure and bulk storage facilities.

The integration of textiles and clothing into normal WTO rules and the elimination of quotas will provide wider market access for Indian exports in an industry that enjoys considerable comparative advantages. On the other hand, it could also increase competition from more efficient manufacturers elsewhere, such as in South and Southeast Asia.

Mr. Aroun Shurie

The Sloan trip to India gave us the immense chance of meeting with Mr. Aroun Shurie, possibly the most influential person in India’s ongoing liberalization process at the time of our trip.

Mr. Aroun Shurie surrounded by students of the MIT Sloan School, April 2004

A well-known author and journalist, Aroun Shourie joined the Bharatiya Janata Party (BJP) in 1998 and was minister in charge of IT and “disinvestment” in the BJP-led coalition government from November 1998 on. During his time in office, Mr. Shourie led six major privatization issues, the latest being the offer on the Indian stock market of 10% of the shares in ONGC, an oil exploration and production company, for $2.2bn.

Like reform itself, the minister has suffered his share of setbacks. One came in September 2003, when the Indian Supreme Court ruled that the privatization of two state oil companies required a vote in parliament. This had the effect of stalling Mr. Shourie’s favored method of disposing of the government's assets—selling control to strategic investors, rather than minority chunks to the market. At the time, Mr. Shourie vented his frustration by saying the ruling showed the difference between India and China: “In India, everybody has a veto.”

In addition to “disinvestment”, Mr. Shourie was in charge of two industries closely related to the recent “Indian miracle”: communications and information technology. The government's hands-off approach to the IT business has allowed it to grow spectacularly, with the emergence of international players such as Infosys or Wipro. In telecoms, liberalization has sparked a boom—India has been adding nearly 2m mobile-phone connections a month since 2003. Yet even there, Mr. Shourie faced setbacks. In January 2004, he failed to gain cabinet approval to open the telecoms sector to majority foreign ownership. He ran into resistance from a wing of his party that is suspicious of globalization.

Both for “disinvestment” and IT, Mr. Shourie –like the other unelected economic liberals- relied heavily on the support of the Prime Minister, Atal Behari Vajpayee.

Shortly prior to the April 20th, 2004 election, Mr Shourie was hoping that the next government would continue reforming, even if Congress, the main opposition party, won. Mr Shourie tended to show optimism on this issue. “Everybody opposes reform in opposition”, argued Mr Shourie, “but in office, finds it the only option”. To confirm his say, it should be remembered the liberalization process was launched by the Congress party in 1991, on the impulsion of Manmohan Singh.

Now that BJP has lost the recent election, and Mr Singh is presumed to take over the job of finance minister, the future will tell if Mr. Shourie was right.

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