MACROECONOMIC

STABILIZATION AND

STRUCTURAL

ADJUSTMENT IN INDIA

ANTARA CHAKRABARTY, ROLL NO.: 08

BASIC DEFINITIONS

Structural Adjustments

“…policy responses to external shocks, carried out with the

objective of regaining the pre-shock growth path of the

national economy” (Balassa, 1981: 1-2)

Macroeconomic Stabilization

Stabilisation involves returning to low and stable inflation and a

sustainable fiscal and current account position.

BACKGROUND

INTERNAL CAUSES:

A repayment of 1981 IMF loans which shot upto 100 billion and the debt-service ratio

had reached 30 per cent by the end of the decade.

A steep fall in foreign exchange reserves to about $ 1 billion (equal to 2 weeks'

imports)

But the basic underlying features of the crisis were high inflation (12 per cent and

rising),

large fiscal and current account deficits (approximately 10 per cent and 3 per

cent of GDP respectively)

Heavy and growing burden of domestic and foreign debt

a sharp downgrading of India's credit rating and a cutoff of foreign private lending.

With this the international creditors chose to shut off such credit at the end of 1980s

that India ran into balance of payment crisis 1990-91, which provided the grounds for

reforms in IMF style stabilization and adjustment strategy.

INFLATION

Source: Routledge Dictionary of Economics (Second edition)

BACKGROUND

EXTERNAL CAUSES:

The roots of the crisis can be traced to India's reaction to the earlier crisis of

1979- 81 when world oil prices doubled. This exogenous shock changed India's

current account position from near balance in 1978 to a deficit of 2 per cent of

GDP (30 per cent of exports) in 1981.

Remarkably, there was hardly any current account adjustment after 1982 despite

favourable developments such as a softening of oil prices and rising domestic oil

production.

Heavy speculative outflow of NRI funds held in India- up to $ 1 billion within a

short span to East Asia

“Confidence crisis”

Predominantly a ‘financial’ crisis

INTERNATIONAL MONETARY FUND (IMF) AND

THE WORLD BANK

The advocacy of structural reforms by the Bretton Woods twins came about in

the aftermath of the second oil shock and was intensified after the debt crisis

which revealed large external imbalances facing many countries

It is in this context that the IMF and the World Bank embarked upon a joint

advocacy of stabilisation aimed at achieving macro-economic stability in the

short term, combined with structural reforms aimed at accelerating growth

through supply side responses.

TYPICAL REFORM PROCESS OF AN ECONOMY

Macro-economic stabilisation

Domestic deregulation of investment production and prices

Liberalisation of foreign trade

Privatisation of the public sector

Financial Sector Reforms and tax reforms

INTERNATIONAL MONETARY FUND (IMF) AND

THE WORLD BANK

International Monetary Fund(IMF)

o One of the major functions of the IMF is to provide its member countries with

financial aid to cover short term gaps in their balance of payments

o A member country requiring an IMF loan more than 50 per cent of its quota

(use of 'upper credit tranches') has to agree to a stabilisation programme with

the IMF and sign a stand-by arrangement (usually running for a year)

World Bank:

o As for the World Bank, it has never made unconditional loans. Even when

virtually all of its loans were for development projects, these loans carried

conditions to which the borrower had to agree and some of these conditions

required policy changes. (Mosley et al, 1990).

REFORM PRIORITIES

Stabilize the economy

Fiscal deficit contraction

To place the economy on a higher growth path through enhanced levelsof investment, and improvements in productivity, efficiency andcompetitiveness.

Therefore, a small IMF loan was drawn from reserve tranche and withoutconditionalities, fresh borrowings were made from Bank of England andJapan in exchange for physical delivery of gold.

But even after this, India’s foreign exchange reserve was enough for only 2weeks’ of import.

NEW ECONOMIC POLICIES (NEP):

The budget of July, 1991 fully reflected the SAP, which came to be known as the New Economic Policy.

Stabilization Structural Reforms

STRUCTURAL ADJUSTMENT PROGRAM, (SAP)

JULY 1991

The SAP was introduced immediately following the formation of the new

government under Prime Minister Narasimha Rao. Without losing any time, the

government applied for a loan of $2.3 billion from IMF and began fulfilling

‘anticipatory conditionalities’.

NEW ECONOMIC POLICY (NEP)

1. STABILIZATION:

Deflation of the economy, reducing the rate of growth and curbing the

‘excessive’ demands

Devaluation* of the rupee, alongwith the initial period of import compression.

In July 1991 there was a devaluation of 22 per cent combined with an

abolition of export subsidies and the introduction of an import

entitlement scheme for exporters

However, stabilization was seen as a temporary strategy; it was mostly

implemented so as to gain back the international investor’s confidence, increase

access to foreign exchange and permit a higher rate of growth.

NEW ECONOMIC POLICY (NEP)

2. STRUCTURAL ADJUSTMENT:

To do away with all kinds of fiscal deficits

It involved not just opening up of the private sector but also bureaucratization,

over manning, and soft budget constraints typical of state enterprise

Imports were liberalized not only to gain access to capital goods, intermediaries

and raw materials needed to restructure and become internationally competitive

but also to expose it to the cutting edge of international competition.

Domestic deregulation: To market forces to allow their disciplining economic

activity.

NEW ECONOMIC POLICY (NEP)

2. STRUCTURAL ADJUSTMENT (CONTD.):

To ensure that private initiative would more than adequately replace the state as

the locomotive of growth, tax policies were rationalized and the tax regime

rendered “less burdensome”.

Tax reforms were mainly liberalized so as to avoid any kind of disincentive to not

save or invest.

Government’s self imposed constraints to reduce the alarming fiscal deficit:

Reduced expenditures on subsidies and administration, rather focused only on

interest payments.

OBJECTIVES OF THE STRUCTURAL ADJUSTMENT

PROCESS:

To do away with or substantially reduce controls on capacity creation,

production and prices and let market forces influence the investment and

operational decisions of domestic and foreign economic agents within the

domestic tariff area

To allow international competition and therefore international relative

prices to influence the decisions of these agents.

To reduce the presence of state agencies in production and trade, except

in areas where market failure necessitates state entry.

To liberalize the financial sector by reducing controls on the banking

system, allowing for the proliferation of financial institutions and instruments

and permitting foreign entry into financial sector.

New

Eco

nom

ic P

olic

y

Liberalisation

Privatisation

Globalisation

SECTORAL ANALYSIS OF THE REFORMS

INDUSTRIAL SECTOR:

1. Removal of capacity controls by ‘dereserving’ and ‘delicensing’ industries, or

abolishing the requirement to obtain a license to create new capacity or substantially

expand existing capacity.

2. Private (domestic and foreign) investment were allowed into sectors such as

power which had been reserved for public sector investment only.

3. The dilution of the Monopolies and RestrictiveTrade Practices (MRTP)

4. Foreign investment regulation. Subsequently, the Foreign Exchange

Regulation Act (FERA) was modified so that companies with foreign equity

exceeding 40 per cent of the total were to be treated on par with the Indian

companies

5. Investment limit in small scale industries was drastically revised upward from Rs. 20

lacs to Rs. 35 lacs.

SECTORAL ANALYSIS OF THE REFORMS

TRADE SECTOR:

1. Liberalization of import trade:

by rapidly reducing the number of tariff items subject to qualitative restrictions,

licensing and other forms of discretionary controls on imports. The peak tariff

rate fell from more than 300 per cent at the start of the 1990s to less than 40

per cent by 2001.

2. Imports of capital goods intermediaries were the first to be substantially

liberalized by placing them under Open General License (OGL) category.

3. 4 items were not dereserved. Namely, arms and ammunitions (defence

equipments), atomic energy, Railway transport, hazardous chemicals.

SECTORAL ANALYSIS OF THE REFORMS

AGRICULTURAL SECTOR:

o The economic reforms did not have any special package designed for agriculture

as there was a presumption that freeing agricultural markets and

liberalizing external trade in agricultural commodities would provide

price incentives leading to enhanced investment and output in that

sector.

o Partial control of fertilizer prices

o Introduction of forward trading in important commercial crops such as jute and

cotton.

FINANCIAL SECTOR REFORMS:

Banking sector, which dominates India’s financial system, the reform involved

three major sets of initiatives:

1. Increasing the credit creating capacity of banks through reductions

in the Statutory Liquidity ratio (SLR) and Cash Reserve Ratio(CRR). This

was combined with greater flexibility in determining the structure of interest rates

on both deposits and loans.

2. To increase competition through structural changes in the banking sector.

Nationalised banks were permitted to sell equity to the private banks

and private banks were on the other hand allowed to enter the banking

area.

3. Banks were provided with greater freedom in determining their asset

portfolios.

.

FINANCIAL SECTOR REFORMS:

4. Selected Indian companies were allowed to access International capital

markets through Euro-equity shares.

5. In case of exchange rate policy, the government moved from an administered

exchange rate to a situation by the end of the decade in which there was

a unified, market determined exchange rate of the rupee which was fully

convertible to the current account transactions

IMPLEMENTATION AND ITS EFFECTS:

The five year period under adjustment (1991-96) did worse than its preceding five

year period (1986-91). The following account will show:

EXPORTS:

o Initial phase was poor but the last three years (1993-96) had a growth averaging

20 per cent.

o However it materialized only in a few new export items; engineering, textiles,

gems and jewelery, cotton and yarn and leather products.

o The expected surge in agricultural export did not materialize. There was a very

low increase in its export.

IMPLEMENTATION AND ITS EFFECTS:

IMPORTS:

o It fell faster than exports (19.4%) in the first year. But then grew faster than

exports in the subsequent years: 12.7% 6.5% 22.9% respectively.

TRADE BALANCE:

o Due to constraining of demand in the first two years, the fiscal deficit declined

from $9.4 billion in 1990-91, to the data presented below:

Year Fiscal deficit (in billion)($)

1991-92 2.8

1992-93 4.37

1993-94 1.29

1993-95 4.82

1995-96 7.02

Source: Dasgupta, B. (1998). Structural adjustment, Global trade and the New Political Economy of Development. New

Delhi: Vistar Publications:

IMPLEMENTATION AND ITS EFFECTS:

CURRENT ACCOUNT DEFICIT:

o The ratio of current account balance to GDP however, declined.

FOREIGN EXCHANGE RSERVE, DIRECT FOREIGN INVESTMENT

AND FOREIGN DEBT:

o India’s foreign exchange reserve rose from around $1 billion to $17 billion in

October, 1995. But this increase was not due to trade surplus, but the sum total

of various types of foreign borrowing from IMF, WB, other international

organizations and foreign government, from NRI deposits and unstable foreign

portfolio investments.

o Only a small part was due to increase in FDI.

o Exchange rate rose from Rs. 31 per US Dollar to Rs. 34 per US Dollar.

IMPLEMENTATION AND ITS EFFECTS:

MACROECONOMIC MANAGEMENT

Years GDP growth rate

(In per cent)

1990-91 4.7

1991-92 1.1

1993-93 5.1

1994-95 5.0

1995-96 6.3

Overall growth rate is slightly less than the figure for 1980s.

Source: Dasgupta, B. (1998). Structural adjustment, Global trade and the New Political Economy of Development. New

Delhi: Vistar Publications:

IMPLEMENTATION AND ITS EFFECTS:

INDUSTRY AND LABOUR:

o Employment in public sector and in organized private sector remained stagnated.

Most of the employment growth was in informal sector.

o The disinvestment process undertaken in India was less oriented towards

improving public sector efficiency than reducing fiscal deficits.

o The only positive side in the later years was the gradual evolution of the

software industry, but this too, catered only a handful.

o Health and education sectors were largely neglected.

IMPLEMENTATION AND ITS EFFECTS:

AGRICULTURE:

o The performance of agriculture was among the worst in all the sectors.

o The overall growth rate was less than 2%, compared to 3% in the 1980s, it led to the

fall of per capita food availability.

o It also fell short of NEP expectations which was required to be 3-4% annual growth.

Years Food production (in

million)(tons)

1991-92 168.4

1992-93 179.5

1993-94 184.3

1994-95 191.1

1995-96 185

Source: Dasgupta, B. (1998). Structural adjustment, Global trade and the New Political Economy of

Development. New Delhi: Vistar Publications:

CONCLUDING REMARKS

The macro-economic crisis of 1991 was primarily the product of fiscaldeterioration.

Re-thinking the concept of devaluation:

o Among professional experts, conventional wisdom suggests that devaluation isthe easiest and most logical across-the-board means of dealing with anexternal imbalance.

o At the other extreme, there are antagonists who claim that devaluation not onlyfails to improve the balance of payments but also induces 'stagflation', i e,stagnation plus inflation, in its wake.

o There are others who believe that even if such a policy is effective in changingtrade flows, it is too costly in comparison with alternative policies forbringing about the same results.

CONCLUDING REMARKS

The quality of the fiscal adjustment is not entirely satisfactory. Too much

of the adjustment has come from a reduction in public investment

The exchange rate policy is necessary but not sufficient for balance of

payments adjustment. Fiscal consolidation and infrastructure

development are also required.

The New Economic Policy thus was a gradual success in reviving the

economy. But this has resulted in many ‘discontents’ related to Globalisation

which has not only led to a decline in the home industries but also spurred

an era of high-consumerism.

GLOSSARY

Capital account: Transactions which do not involve income or expenditure,but change the form in which assets are held. Receipt of a loan, for example, isnot income, but an exchange of cash now for a promise to repay, usually with interestin the future. In a country’s balance of payments, the capital account is a record ofinternational exchanges of assets and liabilities.

Cash Reserve ratio: It is a specified minimum fraction of the total deposits ofcustomers, which commercial banks have to hold as reserves either in cash or asdeposits with the central bank. CRR is set according to the guidelines of the centralbank of a country.

A ratio of cash or cash equivalent holdings to total liabilities of a company, bank,or other financial institution. High cash ratios are supposed to guard against the collapseof such institutions should public confidence in their ability to repay deposits fall.

Currency Devaluation: A fall in the Fixed Exchange Rate which reduces thevalue of a currency in terms of other currencies. The aim of devaluation is toimprove the balance of payments current account. The change in the exchange rate byraising import prices and lowering export prices will reduce imports and increaseexports.

GLOSSARY

Current account: Transactions where the payments are income for therecipient, a country’s balance of payments on current account includes trade ingoods, or visible; trade in services, or invisibles; payments of factorincomes, including dividends, interest and migrants’ remittances from earningsabroad; and international transfers.

Current account deficit: an excess of expenditure over receipts on currentaccount in a country’s balance of payment.

Deflation: A progressive reduction in the price level. This would make realinterest rates exceed nominal interest rates, which might make it impossible tolower nominal interest rates during a slump sufficiently to make real investmentappear profitable.This is known as liquidity trap.

A reduction in activity due to lack of effective demand. This could be broughtabout deliberately by the monetary authorities in order to reduce inflationarypressure, or could occur through a collapse in confidence which the authoritieswere unable to avert.

GLOSSARY

Disinvestment: The process of reducing the capital stock. So far asfixed capital is concerned, this may be by scapping, or by non-replacement of capital goods as they wear out.

Equities: The ordinary shares (UK) or common stock (US) of companies. Theowners of these shares are entitled to the residual profits of companies after allclaims of creditors, debenture holders, and preference shareholders have beensatisfied. Equities this have a higher variance of expected yield than other shares;this effect increases with a company’s gearing.

Inflation: A general sustained rise in the price level that reduces the purchasingpower of that country’s currency. It has been ascribed to increases in themoney supply, excess demand, rises in public expenditure.

Macroeconomic Stabilization: Measures used by governments to influencemajor economic aggregates, especially Gross National Product,Unemployment, Inflation and the Money supply

GLOSSARY

Open General License: It includes categories of commodities which do notrequire an import license but can freely be imported on payment ofthe specified tariffs.

Portfolio: A collection of different assets owned by an individual orfirm. A variety of assets may be preferred to holding a single type of asset forseveral reasons. Holding a variety of assets can reduce risk and allows acombination of some assets and higher income but poor liquidity and otherswith lower income and higher liquidity.

Soft budget constraint: A limit to spending by some public body where thosesupposed to be subject to it believe that the consequences of breaching it willnot be serious. For example, the managers of state-owned firms may believe thatif they run at a loss, or make smaller profits than they have been instructed to,the state will meet the firm’s losses, and not sack them.

GLOSSARY

Stagflation: An unhappy combination of high price inflation, highunemployment and low economic growth. Although the phenomenon was firstextensively discussed in the 1960s, it was present in Western economies before theFirst World War. It was regarded as an indication of the failure of Keynsian-styledemand management and led to a call for income policies, including a tax-basedincome policy.

Statutory liquidity ratio (SLR): It is the Indian government term for reserverequirement that the commercial banks in India require to maintain in the form ofgold, government approved securities before providing credit to the customers.

Structural Adjustment Policy: An attempt to effect a major change to aneconomy, often after an external shock. This policy aims to get the economyback to its pre-shock growth path, improving its Balance of Payments over themedium term, i.e. about five years. The main policy instruments used areincentives to increase production, saving and investment in the public andprivate sectors, together with supporting monetary and budgetarypolicies. Also, there are often specific policies for energy and agriculture. The oil-price increases of 1973 made policies of this kind an urgent priority in manyeconomies.

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