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Subject ECONOMICS

Paper No and Title 10: Sectoral Growth in India

Module No and Title 33: Macroeconomic Stabilisation Policy and Structural

Reforms in India
Module Tag ECO_P10_M33

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Conditions for macroeconomic stability
4. Factors leading to emergence of macro-economic instability in
India
5. Concept of Structural Reforms
6. Interdependence between Macro-economic stability and
Structural Reform
7. Macro-economic Stabilization Process in India
7.1The process of fiscal consolidation in India
7.2Management of inflation
7.3Sustainable Balance of Payment
8 Structural Reforms
8.1Trade and Capital Reforms
8.2Industrial Reforms
8.3Financial Reforms
9 Summary

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
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1. Learning Outcomes
After studying this module, you shall be able to

 Understand the theoretical underpinning of the concept of Macroeconomic

Stabilization
 Understand the conditions for macroeconomic stability.
 Understand the factors that led to emergence of macro-economic instability in
India.
 Know the concept of Structural Reforms.
 Understand the interdependence between the process of Macro-economic stability
and Structural Reform Process.
 Macro-economic Stabilization Process in India
 Structural Reforms in India

2. Introduction

Neoclassical macroeconomic theory treats long-term GDP growth as independent

of any short-term macroeconomic stabilization policies. Alongside, it postulates that
money is neutral and, monetary policy affects prices, not real output in the long run.
While high inflation and price uncertainty are generally considered to be detrimental
to growth, the effect of monetary policy on growth, according to this view, is only
temporary. The ultimate determinant of long-term growth, according to neoclassical
growth models, is technology which is treated as an exogenous variable in such
models.
The forgoing view of economic growth has been challenged by development of
endogenous growth models. The endogenous growth models regard per capita GDP
growth as an endogenous equilibrium outcome of the decisions by rational optimizing
agents including firms, individuals and government. Such an approach endogamies
the determinants of growth (Romer, 1986; Rebelo, 1991)in the form of accumulation
of physical or human capital, evolution of technology through research and
development, and macroeconomic policy. Thus endogenous growth theory provides a
framework to understand the significance of short run stabilization policy in the
process of economic growth.

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
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3. Concept of Macro Economic Stability

Now one need to understand when an economy does tends to be unstable. There are
two aspects of stability of an economy. One relates to internal stability and the other
refers to external stability. Internal stability is defined as a scenario in which real
capacity is at or close to its potential or capacity level, with a low and non-
accelerating level of inflation. In accordance with concept, neither of two scenarios is
considered to be meeting the conditions of internal balance: low inflation coupled
with slow or negative growth or rapid growth coupled with high inflation. On the
other hand, an external balance is defined as a scenario, in which a current account
position is sustained by capital flows with three caveats. First, terms at which capital
flows to the host economy need to be consistent with growth prospects of an
economy. Secondly, it will not entail any restrictions on trade and payment leading to
adequate and relatively stable level of international reserves. An external balance does
not necessarily correspond to a zero current account balance or zero overall balance in
balance of payments. A macro-economic crisis generally takes the form of
accelerating inflation and unsustainable fiscal and current account deficits in an
economy and impairs its normal functioning.

4. What led to Emergence of Macro-economic instability in India?

In simple words, the macroeconomic crisis got slowly built up throughout 1980s
in the country because of imprudent macro-management caused by living beyond
means. The fiscal situation deteriorated throughout 1980s on account of ballooning of
non-plan revenue expenditure, forcing government to increasingly resort to internal
debt. Growing dependence on internal borrowing to cope up with an expanding fiscal
deficit continued eating up the vitals of the economy, eroding its capacity to any
exogenous shock. The automatic monetization of budgetary deficit, made possible by
a complete domination of fiscal policy over monetary policy led to a huge growth in
money supply. This massive expansion in liquidity led to a shooting up of demand
pressures in face of a scenario of stagnant supply .It fueled inflationary pressure and
consequently led to building up of inflationary expectations, creating an overall
inflationary environment in the economy. While inflation in the domestic economy
made our exportable unattractive to rest of the world, the policy instrument of
overvalued exchange rate in an attempt to provide cheap import reduced incentive to

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
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exporters. As a result, current account deficit continued to grow, leading to massive

growth in external debt and the debt service obligations. Thus, it is abundantly clear
that both the aspects of internal and external balance in the domestic economy
remained precarious created a scenario for the economy to reach a dysfunctional
point. Thus, while the economy could absorb larger and more sustained shocks due to
oil price hike in the seventies, it was not possible in the late 1990s. A relatively minor
oil shock due to gulf war brought opens the sores in the economy. Foreign exchange
dropped to a level in January, 1991, which is not adequate to finance imports even for
two weeks. Foreign lending was cut off as reaction to the unsound macro-economic
position. It was a complete loss of face for the country when national gold reserves
had to be a pledged to IMF in exchange for a loan to cover balance of payment debts.
The economy had to grapple with impaired internal and external balances and a
macroeconomic crisis was shaped by unsustainable fiscal deficit, mounting inflation
and unsustainable deficit in current account. Thus macroeconomic stabilization in the
Indian context included fiscal adjustment, control of inflation and adjustment of
balance of payment.

5. Concept of Structural Reform

In its broadest sense, "Structural reforms" simply mean changes to the economic-
governmental structure. If someone believes that there is something wrong with the
society in which they live, they are likely to try and blame a crisis on that belief,
which is intrinsically relates to their ideology. An ideology is a system of ideas and
ideals, especially, one that forms the basis of economic or political theory and policy.
Diverse ideologies of different group of people lead to them to recommend
diametrically opposite “Structural Reforms". For a Marxist, with no faith in market,
such reforms mean ‘nationalization of industry and finance. In stark contrast
"structural reforms" proposed by IMF reflect its predominantly neoliberal ideology, in
which market occupies a pride of place. Structural Reforms in the Indian context
included reforms in trade and capital flows, industrial deregulation, disinvestment and
reforms in public sector and reforms in financial sector reforms.

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
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6. Complementarity between “Macroeconomic Stabilization” and

“Structural Reform”

Standard text book discussions link “Macroeconomic stabilization” to demand

management and “Structural Reforms” to supply management. However, Little and
Joshi (1993) argued that these two aspects of economic reforms cannot produce the
desired impact in isolation and need to be viewed as complementary. They argued that
in the absence of “Structural Reform”, the economy would be back to square one.
Losses of public enterprises would continue to burden the budget, leading to fiscal
deficit again; trade restrictions would hamper the growth of exports, exacerbating
balance of trade problems; and compulsory government capture of private savings
would bring back fiscal indiscipline. Thus the programme of “Structural Reform” is
viewed as indispensable for the success of Macro-economic stabilization process and
must therefore go hand in hand. It may also be argued that “Structural Reform”
process need to be supported by “Macro-economic Stabilization” process as well to
produce a meaningful impact on the economy. This is because the reform process, on
its own, may add to macro-economic pressures. In the short run, trade liberalization
may worsen the balance of payments and financial liberalization may increase fiscal
deficits by raising the cost of government borrowing. Thus the process of “Structural
Reform” may produce undesirable result in the absence of Macro-economic
stabilization policies, and jeopardize the reform process itself. They argued that the
sets of reforms are mutually complementary because no one can work without the
other.

7. Macro-economic Stabilization process in India

Macroeconomic Stabilization consists of having a low inflation with less variation
and a sustainable balance of payment position. Mainly three measures are followed
for this process:

7.1 The process of fiscal consolidation in India

India has been tackling fiscal deterioration by adopting a fiscal adjustment
mechanism to improve fiscal stability. The crux of fiscal consolidation consists of
creating a transparent system of public expenditure, and preventing predatory actors
from controlling the country’s resources. In the past decade, India has enacted
mechanisms to bind governments to fiscal rectitude through formal legal or even
constitutional devices.

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
____________________________________________________________________________________________________

To begin with, certain major fiscal adjustment mechanisms were introduced. They
included Medium-Term Fiscal Reform Programmes (MTFRPs) in 2000-01 for states,
where the guidelines were devised by the Ministry of Finance In 2000–01. It aimed
at reducing wasteful expenditure (cutting low-priority spending) and improving tax
collection or improving the efficiency of the tax administration. However, the
MTFRPs could not achieve its target and, the fiscal situation deteriorated over this
period. A widespread deterioration in the fiscal position with an associated impact on
fiscal sustainability, macroeconomic vulnerability, and economic growth led to an
emerging consensus on the urgent need for imposing statutory ceilings on the central
government’s borrowings, debt, and deficits. This led the passage of FRBM Act.

FRBM Act

The FRBM Act requires that the centre’s fiscal deficit be reduced to 3 per cent of
GDP and the revenue deficit be reduced by an amount equivalent to 0.5 per cent or
more of GDP at the end of each year beginning with 2004–05 and eliminated by
2013–14. The debt-to-GDP ratio is required to be reduced by 68 per cent by 2014–15.
In response to the debt relief package recommended by the Finance Commission in
return for fiscal correction, almost every state except West Bengal and Sikkim has
enacted fiscal responsibility acts. The following table provides the status relating to
financial consolidation during the first decade of operation of FRBM Act.

Table I: First decade of FRBM

Years Gross fiscal deficit Revenue deficit as Growth rate in

as a percent of percent of GDP GDP
GDP
2002-03 5.91 4.40 4.00
2003-04 4.48 3.57 8.10
2004-05 3.88 2.42 7.00
2005-06 3.96 2.50 9.50
2006-07 3.32 1.87 9.60
2007-08 2.54 1.05 9.30
2008-09 5.99 4.50 6.70

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
____________________________________________________________________________________________________

2009-10 6.48 5.25 8.40

2010-11 4.87 3.29 8.40
2011-12 5.89 4.46 6.50

The table shows that the experience with FRBM Act has been a period of missed
deadlines, shifting goal posts along with creative accounting.

7.2 Management of inflation

One needs to tackle the issue of inflation on both demand and supply fronts. Besides
containing fiscal deficit and checking monetary expansion, it is imperative to promote
expansion of agricultural production and manage the supply of food grains and other
essential commodities.
Fiscal dominance of monetary policy, a basic reason for inflation, has moderated in
India as a result of a series of fiscal and monetary policy reforms undertaken over the
past two decades. The most notable of these were (i) movement to a market-
determined interest rate system by introducing auctions of government debt, (ii)
phasing out of the automatic monetization of fiscal deficits through the two
Supplemental Agreements between the Government of India and the Reserve Bank of
India, and (iii) curbing the monetization of debt by enacting the Fiscal Responsibility
and Budget Management (FRBM) Act, 2003 mentioned in the earlier sub-section. It
has been commented in the literature that de-facto monetization has not been
completely phased out. As long as fiscal deficits remain large, the size of market
borrowings would also remain large and impinge upon the conduct of monetary
policy, no matter how the debt management is conducted. While in principle the
Reserve Bank uses open market operations to impact liquidity and monetary
conditions, in practice it is not easy to decipher what part of the open market
operations were undertaken purely on these very considerations and what part might
have been influenced by the consideration that large government.
On the supply side, government undertakes various measures to accelerate industrial
and agricultural growth rate. For agriculture, initially Land Reforms were undertaken
to enhance the efficiency of production and currently initiatives are taken on
technological front to increase both intensive and extensive cultivation. Agricultural
credit is another field which is being used to stop the exploitation of small farmers by
big money lenders. The industry has grown initially on the basis of ‘Industrial Policy’
of India and at present various initiatives like ‘Make in India’ and development of
industrial corridors has been started. However, the growth rate of agriculture has
ECONOMICS Paper 10: Sectoral Growth in India
Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
____________________________________________________________________________________________________

remained satisfactory and industrial production has shown modest increase. But in
case any one of them slows or does not match up with the population growth rate,
then it will necessarily cause prices to rise. Thus, it is essential for the government to
always keep a check on the growth rate of output and take necessary steps as
dynamics of an economy changes.

7.3 Sustainable Balance of Payment

India faced a severe balance of payment crisis in 1990-91. After that the position has
improved to a larger extent. At present India enjoys the foreign reserves of about
352020 USD Million. In early 1990s imports were compressed mainly to curb huge
current account deficit. Imports were liberalized only when India was considered to
be in a relatively comfortable foreign exchange reserves position. Further, there was
huge deficit in the balance of payments position from Sixth to Ninth Plan periods.
This was due to tremendous rate of growth of imports along with a poor rate of
growth of exports. The trade deficits during these four plans were so heavy that it
could not be offset by the flow of funds under net invisibles. The exchange rate
management has a crucial role in controlling the balance of payment position. India
follows the liberalized exchange rate management system (LERMS), which is a dual
exchange rate for the conversion of foreign reserves earned by the citizens of India.
This system has been very successful in managing the volatility. Along with this
effort, the Government also launched the India Development Bonds aimed at
mobilizing foreign funds. The balance of payments position in India showed a
gradual improvement since 1991-92 with exports covering a larger proportion of
imports than in the earlier years. As a result of these efforts reserve accumulation
during 2004-05, at around four-fifths of such accumulation during 2003-04, and this
helped maintained India’s status as one of the largest reserve holding economies in
the world.

8. Structural Reforms in India

As noted before structural reforms are designed basically to deal with sectoral
problems pertaining to the supply side of the economy. Since the initiation of ‘New
Economic Policy’ of 1991, Government of India has undertaken various steps to
strengthen the structure of the economy. We hereby describe few measures.
8.1 Trade and Capital Flows Reforms:

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
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In order to achieve the goal of globalization and integrating the Indian economy with
the rest of the world India took many steps like, devaluation of rupee in July 1991,
convertibility of rupee on trade account, considerable reduction in tariffs rates and de-
canalization of many items. The devaluation of rupee enhanced the competitiveness
of Indian products in the world market. The liberalization of imports with the
reduction of high tariffs has also resulted in equality in prices of the commodities
produced domestically and in foreign countries. Along with de-canalization, Export
processing zones and Special Economic Zones have been created to boost the exports.
Finally, Foreign Direct Investment has been allowed in many industries. Like the
Government has relaxed the norms for area restriction and the requirements related to
minimum capitalization in the infrastructure development sector.

8.2 Reforms in Industrial Policy:

Industrial policy was reconstructed to a great extent and most of the industrial
controls were dismantled. Substantial deregulation of the industrial sector was done in
order to bring in competition and increase efficiency. Industrial licensing was almost
abolished except some industries. The list of industries reserved solely for the public
sector included iron and steel, heavy plant and machinery, telecommunications and
telecom equipment, minerals, oil, mining, air transport services and electricity
generation and distribution was drastically reduced to three: defense aircrafts and
warships, atomic energy generation, and railway transport. Further, restrictions that
existed on the import of foreign technology were withdrawn.

8.3 Financial sector reforms:

Financial sector reforms have always been taken as an indispensable part of the
comprehensive policy reforms in India. India has identified that these reforms are
important for enhancing the efficiency of resource compilation and their allocation in
the economy as well as for the overall macroeconomic stability. The reforms have
been driven towards liberalization and various measures like liberalization in the
interest rate and reserve requirements have been taken to achieve these goals. On the
other hand, the government has accentuated on stronger regulation focusing at
intensifying prudential norms, transpicuous manner and supervision to mollify the
chances of systemic risks. Today the Indian financial structure is intrinsically strong,
operationally diverse, well organized and globally ambitious. During the last two
decades, the Indian financial system has been increasingly deregulated and

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India
____________________________________________________________________________________________________

manifested to global financial markets accompanied with the launching of new

instruments and products.

9. Summary

 Endogenous growth theory models forms the basic framework to understand

the importance of stabilization policy in the process of economic growth.
 Macroeconomic stability is both in terms of internal and external aspects. The
internal is with regard to the real capacity of production in the economy and
the external refers to the current account position of the nation.
 In India macroeconomic instability was mainly due to imprudent macro-
management caused by living beyond means.
 Structural Reforms in the Indian context included reforms in trade and capital
flows, industrial deregulation, disinvestment and reforms in public sector and
reforms in financial sector reforms. But the process of “Structural Reform”
may produce undesirable result in the absence of Macro-economic
stabilization policies

ECONOMICS Paper 10: Sectoral Growth in India

Module 33: Macroeconomic Stabilisation Policy and Structural Reforms in
India