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Indian Policy Forum 2004 – Volume 1: Editors’ Summary

Suman Bery, Barry P. Bosworth, and Arvind Panagariya

indiapolicyforum2004.gifThis inaugural issue of the India Policy Forum, edited by Suman Bery, Barry Bosworth and Arvind Panagariya, includes papers on the trade policies that would do the most to enhance India’s future growth prospects, analyses of recent developments in India’s balance of payments and an examination of the performance of the Indian banking system. The editors’ summary appears below, and you can download a PDF version of the volume, purchase a printed copy, or access individual articles by clicking on the following links:

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EDITORS’ SUMMARY

The India Policy Forum (IPF) is a new journal, jointly promoted by the National Council of Applied Economic Research (NCAER), New Delhi, and the Brookings Institution, Washington, D.C., that aims to present high-quality empirical analysis on the major economic policy issues that confront contemporary India. The journal is based on papers commissioned by the editors and presented at an annual conference. The forum is supported by a distinguished advisory panel and a panel of active researchers who provide suggestions to the editors and participate in the review and discussion process. The need for such real-time quantitative analysis is particularly pressing for an economy like India’s, which is in the process of rapid growth, structural change, and increased involvement in the global economy. The founders of the IPF hope it will contribute to enhancing the quality of policy analysis in the country and stimulate empirically informed decisionmaking. The style of the papers, this editors’ summary, and the discussants’ comments and general discussions are all intended to make these debates accessible to a broad nonspecialist audience, inside and outside India, and to present diverse views on the issues. The IPF is also intended to help build a bridge between researchers inside India and researchers abroad, nurturing a global network of scholars interested in India’s economic transformation.

The first India Policy Forum conference took place at the NCAER in
Delhi on March 26–27, 2004. In addition to the working sessions, the occasion
was marked by a public address given by Stanley Fischer, vice chairman
with Citigroup International and a member of the IPF advisory panel.
This inaugural issue of the IPF includes the papers and discussions
presented at that conference. The papers focus on several contemporary
policy issues. The first two papers provide alternative perspectives on
the trade policies that would do the most to enhance India’s future
growth prospects in the context of ongoing developments in the global
trading system. The three papers that follow are devoted to an analysis
of recent developments in India’s balance of payments and their implications
for the future exchange rate regime, the integration of exchange rate policy with other aspects of macroeconomic policy, and capital account
convertibility, respectively. The sixth paper is devoted to an examination of
the performance of the Indian banking system and the implications of the
dominant role of government-run banks.

India’s Trade Reform, by Arvind Panagariya

The first paper, by Arvind Panagariya, provides a broad review of
India’s external sector policies; the impact of these policies on trade flows,
efficiency, and growth; and the future direction trade policies should take.
Since trade policies are a means to an end, namely faster growth and
improved efficiency, and since trade policies support other domestic policies,
Panagariya’s review necessarily ranges into these areas as well.
Finally, to place India’s performance in perspective, Panagariya makes
extensive comparisons throughout between Indian and Chinese outcomes
over the past two decades (1980–2000), a period when both economies
have chosen to reintegrate into the world economy.

India’s growth experience since 1950 falls in two phases. The first thirty
years were characterized by steady growth of around 3.5 percent; thereafter
growth has tended to stay in the 5 to 6 percent range. Panagariya links this
differential growth performance with the imposition and subsequent relaxation
of microeconomic controls, particularly in the external sector. In turn
he divides these external sector policies into three phases. Between 1950
and 1975 the trend was toward virtual autarky, particularly after a balance of
payments crisis in 1956–57. This was succeeded by a period of “ad hoc
liberalization” starting around 1976, when reform of quantitative restrictions
on trade was complemented by deregulation of industrial licensing in
certain sectors. A further balance-of-payments crisis in the period from late
1990 to early 1991, concurrent with a general election, provided the background
for a switch to deeper and more systematic liberalization, which, in
fits and starts, continues today.

In the merchandise trade area the focus of reform has been to reduce
tariff levels, particularly on nonagricultural goods. This has been done by
gradually reducing the peak rate and reducing the number of tariff bands.
In 1990–91 the peak rate stood at 355 percent, while the simple average of
all tariff rates was 113 percent. By early 2004 the peak rate on individual
goods was down to 20 percent, though there were notable exceptions,
such as chemicals and transport equipment. Similarly, there has been less
than ideal progress in reducing end-user and other exemptions. In nonindustrial
areas there has been substantial liberalization of trade (and investment)
in services, but following the OECD example, less in agriculture.

Panagariya next reviews the impact of this liberalization on trade flows,
on efficiency, and on growth, in many cases using China as a benchmark.
India’s share in world exports of goods and services—which had declined
from 2 percent at Indian independence in 1947 to 0.5 percent in the
mid-1980s—bounced back to 0.8 percent in 2002, implying that for
roughly twenty years India’s trade has grown more rapidly than world
trade. In addition, the deeper reforms of the 1990s yielded a pick-up of
almost 50 percent over the previous decade, from 7.4 percent to 10.7 percent.
Encouraging though these numbers are in light of India’s past
performance, they pale in comparison with the Chinese record over the
same period. Aside from any issues that may arise in the measurement of
Chinese GDP at a time of rapid institutional and economic change, the
combined share of exports and imports of both goods and services rose in
China from 18.9 percent in 1980 to 49.3 percent in 2000, according to
World Bank data. For India, the comparable numbers were 15.9 percent
(in 1980) and 30.6 percent (in 2000).

The increase in India’s trade intensity has been accompanied by significant
shifts in composition. The most dramatic has been the increased share
of service exports in the 1990s. Within industry, exporting sectors with
above-average growth tended to be skill- or capital-intensive rather than
labor-intensive, while on the import side the share of capital goods imports
declined sharply. In the area of services, rapid growth was exhibited by
software exports and recorded remittances from overseas Indians. However,
tourism receipts remain below potential. With regard to trade partners,
the main shift over the 1990s was a move away from Russia toward
Asia, particularly developing Asia. An interesting recent development has
been the rapid expansion of India’s trade with China.

Panagariya then reviews the evidence on the impact of liberalization on
static efficiency and on growth. One common approach is to use a computable
general equilibrium (CGE) model to estimate the effects of the
removal of trade distortions. The one study cited estimates the impact as
raising GDP permanently by 2 percentage points. Additional domestic liberalization
could raise this figure to 5 percentage points. Panagariya argues,
however, that such models miss some key sources of gains. He cites two in
particular: the disappearance of inefficient sectors and improvements in
product quality. In addition, disaggregated analysis at the five-digit SITC
level reveals far more dynamism in product composition of both exports
and imports than is revealed at the two-digit level. This suggests greater
gains from trade and improved welfare from enhanced choice than is captured
in more aggregate models.

The links between liberalization and aggregate growth—or growth
in total factor productivity (TFP)—have been controversial both in India
and elsewhere in the emerging economies of Asia. In the case of India,
the focus has been almost exclusively on manufacturing. After reviewing
several studies, which admittedly differ in methodology and data quality,
Panagariya judges that the weight of the evidence indicates that trade liberalization
has led to productivity gains. Notwithstanding this reasonably
positive assessment, Panagariya reminds us that overall, Indian industry’s
performance in the 1980s and 1990s has been pedestrian, particularly compared
with that of services.

The poor performance of Indian industry and the stronger growth performance
of Chinese industry form the backdrop for Panagariya’s final section,
on future policy. He discusses four issues: domestic policies bearing
on trade; autonomous liberalization; regional trade agreements; and India’s
participation in multilateral negotiations. With regard to the first, the
central question for Panagariya is why Indian industry’s response to liberalization
has been more sluggish than China’s. Panagariya attributes this in
part to differences in economic structure but also to differences in the two
countries’ domestic policies. He argues that it is easiest to expand trade in
industrial products, and it is easier to do so if the industrial sector represents
a large share of national value added. As far back as 1980, the share of
industry in China was 48.5 percent, while in India it was half that, at 24.2
percent. Two decades later things are not very different. Panagariya makes
a further interesting point: a relatively small industrial sector also reduces
the capacity of the economy to absorb imports, leading to a tendency
toward exchange rate appreciation (although even China has not been
immune from this tendency). He concludes that it is imperative to stimulate
industrial growth and cites reform in three areas as being essential: reduction
of the fiscal deficit; reduction and ultimately elimination of the list of
manufactured products “reserved” for small-scale industry; and reform of
the country’s labor laws, which make reassignment or retrenchment of
workers prohibitively difficult in the so-called formal or organized sector.

Authors

Turning next to autonomous trade reform, Panagariya is critical of the
view, widely held in India, that the tariff structure ought to favor final goods
over intermediates. He also notes that the current tariff structure remains riddled
with complexity. He urges the authorities to move quickly to a single
uniform tariff of 15 percent for nonagricultural goods and to move to a uniform
tariff of 5 percent by the end of the decade. With regard to agriculture,
Panagariya points out that India stands to gain from autonomous tariff
liberalization given its potential as an agricultural exporter. He also
addresses the issue of “contingent protection,” wherein India’s liberal
use of antidumping regulations has clearly had protectionist intent. Panagariya urges changes in the antidumping procedures currently in place and
also greater use of safeguard measures, as they are applied on a nondiscriminatory
basis to all trading partners.

While India has traditionally taken comfort in a multilateral rule-based
system of international trade, it has more recently embarked on an ambitious
program of regional trade negotiations. It has signed free trade area
(FTA) agreements with Sri Lanka and Thailand and is in the advanced
stages of negotiating an FTA with Singapore. Panagariya analyzes the
global, regional, and domestic factors that have brought about this shift in
strategy—essentially the weakening of the U.S. commitment to multilateral
negotiations, together with political imperatives. Panagariya observes that
for a relatively protected economy, trade diversion and the associated
revenue loss should be important concerns. He is also concerned that
preoccupation with FTAs diverts attention from both unilateral liberalization
and multilateral negotiations, each of which yields greater return for
the effort expended. However, Panagariya concedes that there is a strategic
case for FTAs, both to exert leverage in the multilateral sphere and to create
a template that reflects India’s interests in future bilateral and multilateral
negotiations. In this context he is critical of the template developed in the
agreement on the South Asian Free Trade Area (SAFTA), which, in his
view, is cluttered with many nontrade issues. In the specific case of a
U.S.-India FTA, he believes that there is a strong case for an agreement in
services, with mutually beneficial exchange of market access.

The paper ends with a discussion of India’s interests in ongoing multilateral
trade negotiations. Panagariya’s main point is that India has a strong
interest in successful conclusion of the Doha Round and could agree to the
U.S. proposal aimed at eliminating tariffs on industrial goods by 2015. As
noted before, India also has interests in improved market access in agriculture;
given the considerable water in its bound tariffs, some concessions
should be possible, particularly if accompanied by reductions in subsidies
by rich countries.

Should a U.S.-India FTA Be Part of India’s Trade Strategy, by Robert Z. Lawrence and Rajesh Chadha

The 1990s and the new millennium have seen a massive proliferation of
preferential trade arrangements (PTAs), which typically lead to free trade
among two or more countries, as, for example, under the North American
Free Trade Agreement (NAFTA). Until recently, Asian countries had more
or less stayed away from these arrangements, but this is changing rapidly,
with many countries in the region now forging free trade areas. In their
paper, Robert Lawrence and Rajesh Chadha assess the likelihood and
benefits of the negotiation of a free trade area between India and the
United States. Like Panagariya, Lawrence also embeds his discussion of India’s trade policy within the framework of the larger Indian reform
effort.[1] Following Ahluwalia, he characterizes Indian reform since 1991 as
incremental, not radical.[2] While there has been deepening consensus about
the broad direction of reform within the policy elite, excessive clarity on
endpoints and on the pace of transition is seen to be politically risky. Trade
policy reform has been an important part of this liberalization effort, and it
has been similarly characterized by a clear direction but fitful implementation
and shifting promises as to endpoints.

Lawrence accepts that this strategy has been relatively successful in producing
steady growth without major policy reversals or financial crises
over the last decade. Yet, like Panagariya, he notes that trade reform is a job
only half done. India’s tariff rates remain among the world’s highest, and
there remain significant barriers to foreign investment. Within India, there
continues to be political resistance to liberalization. Lawrence asks what
the best trade and reform strategy for India is now, given the tasks yet to be
accomplished.

Lawrence articulates three options available to India at this time: continued
incremental unilateralism dictated, as in the past, by domestic
concerns and feasibility; more active engagement with multilateral negotiations
through the World Trade Organization (WTO); and what he calls a
multitrack approach, whereby deeper bilateral free trade agreements complement
the first two channels. Within this larger context the specific question
he explores in depth is what role might be played by an FTA between
India and the United States. He recognizes that consideration of such an
FTA is at best at a nascent stage in official circles and that it is far from
being an idea whose time has come. Nonetheless, his core thesis is that
given India’s domestic reform goals, a multitrack approach centered on a
U.S.-India FTA would be superior to excessive reliance on the WTO, given
likely outcomes under the ongoing Doha Round. This is the argument that
the paper attempts to substantiate.

Lawrence first considers a purely defensive motive for such a FTA.
From this perspective, the key issue is to establish a legal and institutional
framework for keeping trade in information technology (IT) services free.
Noting the rapid growth in India’s export of such services, Lawrence cites
studies that suggest that this trade is still in its infancy. Given that the
United States is currently the destination of two-thirds of India’s IT
services exports—and that this share could well be maintained—trade
between the United States and India has the potential to become one of the
most dynamic examples of trade in global commerce.

Will this growth be allowed to take place? Protectionist pressures in the
United States already are strong. Outsourcing is headline news in the
United States, and federal and state governments are taking politically visible
stands to restrict the practice under government contracts. While some
of this is undoubtedly election year politics, preserving access for India in
the U.S. market is a genuine challenge. Lawrence explores various options
available to India to preserve its access, including through the General
Agreement on Trade in Services (GATS) agreement within the WTO. He
notes that GATS operates on a positive list approach, which can create
some ambiguity as to what forms of market access have been bound. By
contrast, services liberalization in U.S. bilateral agreements already uses
a negative list approach: trade is allowed unless it has specifically been
prohibited.

Lawrence then explores the possibility, from the U.S. perspective, of an
FTA with India. He notes that the United States first moved away from
exclusive reliance on multilateral negotiations as far back as the 1980s,
when it signed FTAs with Canada and Israel, followed by NAFTA in 1993.
Under the Bush administration the pace of negotiation of bilateral agreements
has accelerated dramatically. Agreements with Chile, Singapore,
and Jordan have been implemented; those involving the Central American
Free Trade Area (CAFTA), Morocco, and Australia have been completed;
and numerous others are either under active negotiation or planned.

In this environment Lawrence believes that an FTA with India would be
seen by the U.S. authorities as being of great strategic interest in the larger
U.S. negotiating strategy but also politically difficult to achieve, given the
current mood in Congress. But he is skeptical of the possibility that such an
agreement could be restricted to services alone—as proposed, for example,
by Panagariya and by a recent task force of the Council on Foreign Relations.
The United States is unlikely to forgo the opportunity of obtaining
preferential access for the exports of its goods to the Indian market. In addition,
dropping all goods trade in an agreement with India would create a difficult
precedent for the United States in its other FTA negotiations, in which, with
few exceptions, there have not been sectoral opt-outs.

Accordingly, in his discussion Lawrence deals with the case for a comprehensive
U.S.-India FTA with most of the features of those that the
United States already has concluded. These include a negative list for services; investment provisions with a few sectoral exclusions; full national
treatment for U.S. companies; intellectual property rules that might be
more comprehensive than those in the WTO; and additional provisions
relating to labor, environmental standards, technical barriers, and government
procurement. While the phase-in periods may differ for the two sides,
once the agreement was fully implemented (generally in fifteen years), the
obligations would be symmetric.

Lawrence readily concedes that willingness to sign an FTA agreement
of this scope with the United States would be a radical departure for India
in a number of respects. While much Indian trade liberalization has been
unilateral, India has so far been a strong advocate of multilateral trading
rules, but there too its efforts have concentrated on obtaining special and
differential treatment for developing countries. As Panagariya has also
noted, India has only lately entered the game of bilateral FTAs, so far with
countries in Asia, but even in terms of goods trade these have not been comprehensive.
A U.S.-India FTA would have major implications for India’s
trade and domestic policies. It is the positive (or offensive) case for such a
radical shift that Lawrence next examines.

He starts by offering some hypotheses on the political economy of liberalization.
At the beginning, an opportunistic and piecemeal approach
may be necessary to create constituencies for liberalization. But unilateralism
carries the risk of reversal, and such policy uncertainty can inhibit the
private investment decisions needed to shift the economy in the direction
of its comparative advantage. Trade agreements, whether bilateral, regional,
or multilateral, can impart credibility to commitments by the home government,
making it more likely that liberalization will be successful. Such
enhanced credibility is not costless, however. In contrast to an incremental
approach, a comprehensive agreement means that many political battles
have to be conducted simultaneously. This drawback can be offset by the
fact of reciprocity, which can be used to develop coalitions of exporters
who favor the trade reform. A further set of allies is provided by proponents
of domestic reform, who can argue that the domestic reforms necessary for
domestic growth can also deliver improved access to international markets.
Lawrence believes that such a strategy was followed by the Chinese in connection
with their accession to the WTO.

If these are some of the benefits of comprehensive reciprocal agreements,
the question of what type of reciprocal agreements, multilateral or
bilateral, remains. This is the choice addressed by Lawrence in the remainder
of the paper. In making his assessment, Lawrence uses as a yardstick
the impact of each of the two routes in assisting India to undertake changes
in its own interest while avoiding constraints that have the potential to damage
its welfare.

In order to assess the impact of a U.S.-India FTA, Lawrence examines
some of the FTAs that the United States has recently negotiated. His review
makes it clear that the institutional changes needed in the Indian economy
would indeed be deep but in most areas they would prod Indian policymakers
to move in directions that are inherently desirable. A particular concern
of Indian policymakers is the introduction of labor and environmental
standards through an FTA, and Lawrence clears up several misconceptions
in this area. Recent bilateral agreements place the emphasis on each government
enforcing its own domestic environmental and labor laws and not weakening
those laws or reducing protections to encourage trade or investment.
While these obligations are backed by the dispute settlement provisions of
the agreements, trade measures may not be used to retaliate. On balance,
implementing a U.S.-India FTA at this time would probably help to bolster
and accelerate many dimensions of economic reform, but Lawrence notes
that the benefits depend crucially on taking a range of complementary
actions. Failure to do so could lead to conditions that were worse than before.

Lawrence then examines whether a successful conclusion to the Doha
Round could deliver equivalent benefits to the cause of Indian reform. In so
doing he notes that those who argue for exclusive reliance on multilateral
liberalization compare actual FTAs with an idealized version of multilateral
liberalization. But actual achievement under multilateral liberalization
is heavily conditioned by the specific rules of trade negotiations, which
may not actually result in significant domestic liberalization at all. As a
developing country, India benefits from the “special and differential treatment”
provisions of the General Agreement on Tariffs and Trade (GATT),
while benefiting from the most-favored nation provisions of the multilateral
system. An additional institutional feature is the gap between applied
and bound tariffs, which is particularly large where agricultural goods are
concerned. A final feature is what Lawrence (following Jagdish Bhagwati)
calls “first difference” reciprocity, where the offers made by each nation are
measured against their protection levels at the beginning of the round.

Taking these elements into account and reviewing the actual performance
of past rounds in reducing industrial tariffs, Lawrence comes to the
strong conclusion that the current WTO system actually impedes a developing
country like India from using WTO agreements to support meaningful
liberalization; he also believes that the diffuse reciprocity involved in
the most-favored nation system is not a strong catalyst for rallying exporter
interests in favor of import liberalization.

Having provisionally concluded that an FTA would be of greater assistance
than exclusive reliance on multilateral negotiations, Lawrence then
explores the benefits to India of blending the two approaches in what he
calls a multitrack approach. In his view, a U.S.-India FTA would certainly
make India a more attractive negotiating partner for third countries hoping
to match the access obtained by U.S. firms. Equally, assuming that it preceded
the conclusion of the Doha Round, willingness to sign an FTA with
the United States would also improve India’s negotiating credibility in the
multilateral sphere. India could then challenge developed countries to
improve their own offers dramatically by indicating a willingness to engage
in extensive multilateral liberalization itself. A comprehensive FTA with
India would also be of strategic importance to the United States in its current
policy of competitive liberalization. This would strengthen India’s
hand in its negotiations with the United States, while strengthening the U.S.
hand in negotiating with other significant but reluctant partners.

The paper ends with some quantitative welfare simulations undertaken
by Lawrence’s coauthor, Rajesh Chadha of the NCAER, using a computable
general equilibrium model of world production and trade developed
by the NCAER and the University of Michigan. The simulations
deal only with the impact of liberalization on trade in goods. The model is
designed to capture the long-run impact of an agreement. More crucially, it
is a real model that holds employment and the trade balance constant; as
such it captures the second-round adjustments needed to restore full
employment in the economy following an initial trade shock.

A U.S.-India FTA is compared first with the current situation and then with a number of counterfactuals. The results reveal that aggregate welfare
gains are greatest under multilateral liberalization, next greatest under unilateral
liberalization in each country, and least under a bilateral FTA, but
they note that even in the last case the effects are positive. The results also
point out asymmetries between the United States and India in unilateral and
multilateral liberalization, given the differences in the openness of the two
economies. Indian and world welfare both rise significantly when India liberalizes
unilaterally, while for the United States the greatest welfare gains
flow from multilateral liberalization.

Lawrence concludes that the more difficult decision facing India today
is whether to opt for reciprocal approaches in lieu of the unilateral approach
that it has traditionally pursued. There are gains in credibility to be
achieved, but these could entail reduced policy space and require a significant
agenda of complementary reform to achieve their full effect. Should
India choose to pursue the reciprocal route, he suggests a U.S.-India FTA
as worthy of serious consideration, precisely because of its comprehensive
and deep character.

Foreign Inflows and Macroeconomic Policy in India, by Vijay Joshi and Sanjeev Sanyal

India has had a turnaround in its balance of payments in recent years,
with a swing in the current account from a deficit to a surplus and rapid
growth in the capital account surplus. It has used those inflows to build up
substantial holdings of foreign exchange reserves that now stand at
$120 billion. While the initial reserve accumulation was welcome insurance
against the risk of unanticipated future outflows, the current level is adequate
to meet any foreseeable challenge, and policymakers need to develop
an exchange policy that goes beyond simple reserve accumulation. Should
India accelerate the process of capital account liberalization, perhaps
allowing the export of capital by residents? Should it allow an appreciation
of the exchange rate or speed up the liberalization of the trade regime?
Above all, how should the exchange policy be integrated with the broader
concerns of domestic economic policy?

In their paper, Vijay Joshi and Sanjeev Sanyal provide a broad review of
the external aspects of Indian macroeconomic policy over the past decade.
They use that review a

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