Final Paper for India Class - Joshua Spinak

15.227B Special Seminar in International Management Final Class Project: A Macroeconomic Analysis of the Indian Economy Joshua Spinak MIT | Sloan School of Management India: A Macroeconomic Analysis India has experienced cathartic growth since it opened its economy in 1991 and began policies of privatization Ten percent of the population rose out of poverty in the period from 1993-2000 Today there is a general feeling of optimism and hope for a better future This paper examines the sources of India’s growth and describes the country’s economy using basic macroeconomic analysis It illustrates India’s position on the BBNN and ISLM, and within a framework for understanding transition economies Finally, the paper outlines a strategy for continued growth and development The Indian BBNN The BBNN model shows an economy’s real exchange rate, which is the point of equilibrium between the labor market and the balance of payments The labor market is represented by a curve (NN) that includes all of the points in which there is no pressure on wages to either increase or decrease This is otherwise known as the natural rate of unemployment The balance of payments is represented by a curve (BB) that shows all the points in which the value of exports is equal to the value of imports At any of these points, the economy has neither a current account deficit nor a current account surplus Included in the BBNN is an additional curve, called the social peace curve Social peace relates the happiness of the populace: if the economy is significantly below the social peace curve, there will be social unrest (India’s BBNN is illustrated in figure of the appendix.) Labor participation in India is 39% overall, 52% for men and 26% for women The majority of the population lives in rural areas, and agriculture employs approximately two thirds of the labor force while providing for one fourth of the country’s GDP India produced a total of 600 million tons of food per year, making it one of the world’s top producers of food Manufacturing is responsible for an additional one fourth of GDP The services sector, which has seen enormous growth in the last twenty years, has increased from 12.8% of GDP in 1980 to 48.8% of GDP in 2001 Population growth and migration from the country to the city both have a profound effect on the natural rate of unemployment (the NN curve.) India’s population exceeded billion in March of 2001 Of this population, 742 million people live in the country Although population growth is slowing, it is expected to continue until 2030, when the country’s population will reach 1.5 billion, making it the largest in the world Population growth pushes the NN curve outward by increasing the number of workers looking for jobs In addition, migration from rural areas to urban areas further pushes the NN curve to the right by flooding the industrial markets with more potential workers By 2010, the urban population is expected to comprise one third of the total population The immediate effects of population growth and migration are additional unemployment and pressure on wages to decrease In the 50s, 60s, and 70s, the Indian economy grew at a rate of only 3.5%, or 1% growth in GDP per person, which came to be known as the “Hindu rate of growth.” The economy picked up as economic reforms were implemented, reaching a high of 7.7% in 1995/1996 In 2002/2003, lower growth of 4.4% was attributed to a poor monsoon and low agricultural output Although this shows the dependence of the Indian economy on its agricultural sector, growth of 4.4% despite a poor monsoon also demonstrates that the economy is diversifying into other sectors Today India has one of the six fastest growing economies in the world In the second quarter of 2003, GDP growth was 8.4% Growth for the fiscal year 2002/2003 is estimated at 8.2% (See figure 5) India achieved its first current account surplus in 24 years in the fiscal year 2002/2003 Major growth in the services sector, including information technology outsourcing, as well as inflows from the Indian Diaspora contributed to the surplus In 2002/2003, the current account surplus totaled USD$4.1 billion, while the trade deficit was USD$7.7 billion India’s principal goods exports are cotton, yarn, textile, readymade garments, leather goods, gems, jewelry, and agricultural and processed food products Exports of merchandise grew by more than 20% in 2002, and the foreign reserves increased to USD$109.6B Increased productivity and exports from the IT services industry moves the balance of payments (BB) curve outward In addition, capital inflows from Indians abroad increase the surplus and move the economy’s position on the BBNN inward Economic reforms, if suited to growth, will contribute to outward movement in the BB curve, increasing the value of the current account Reforms began in earnest in 1991 following India’s payments crisis, in which the country had to borrow money from the International Monetary Fund (IMF) to escape defaulting on payments Before providing funding, one of the conditions the IMF imposed on India was increased liberalization of its economy One of the most significant reforms was privatization of State Owned Enterprises (SOEs.) Privatization has already had a profound effect on the economy, despite moving slower than many proponents had hoped for Privatization initially targeted the power, steel, oil refining and exploration, road construction, air transport, telecom, ports, mining, pharmaceuticals, and financial sectors Also, restrictions limiting the size of companies in the garments and textiles industry were removed Federal Direct Investment (FDI,) critical for promoting competition and efficient industry, was welcomed in most sectors Competition was also fomented by reducing licensing and other governmental controls, although labor relations and bankruptcy are still largely managed by the government Many tariffs were lowered, and most import quotas were eliminated In addition, reforms have increased the efficiency and attractiveness of India’s capital markets, which has attracted investments from foreign institutional investors Exchange rate policy affects an economy’s position on the BBNN by determining the competitiveness of its industry With an artificially low exchange rate, exports will be expensive and there will be pressure on wages to decrease The opposite is true for an artificially high exchange rate In 1991, the rupee was devalued by 22% to better reflect the real exchange rate, and a market exchange rate was introduced in 1993 Although exchange rate policies have become much more flexible, capital outflows are still regulated because of insecurities resulting from a weak banking sector, relatively high fiscal deficit, the East Asian financial crisis, and conflict with Pakistan The rupee has been appreciating with respect to the dollar recently, in part because of India’s growing foreign exchange reserves and continued economic liberalization Lastly, social indicators have improved since the economy opened up and economic reforms began in 1991 The biggest gains have been in the south and along the west coast, areas which have attracted industry and high tech Literacy and life expectancy have increased significantly All of these factors contribute to a movement upward in the social peace curve (See figure 1) The Indian ISLM The ISLM model is comprised of two curves, the IS curve and the LM curve The IS curve (I stands for Investment and S stands for Savings) describes the market for real goods and services, and the LM curve (L stands for Liquidity and M stands for Money) describes the supply of and demand for money in an economy A movement in either curve has an affect on both interest rates and the production of goods and services A country’s fiscal policy is responsible for movements in the IS curve, whereas its monetary policy is responsible for movements in the LM curve The ISLM is useful for explaining the effects that fiscal and monetary policies have on interest rates, inflation, and shortterm output (India’s ISLM is illustrated in figure of the appendix.) For many years, India practiced expansionary fiscal policy, as witnessed by its large fiscal deficit The national deficit reached a high of 6.6% of GDP in 1991, when the country suffered the payments crisis Despite having recovered from the payments crisis, India still maintains a large deficit In 2002/2003 the national deficit was 5.9% of GDP, and state deficits were an additional 4.2% of GDP National and state deficits are the result of excessive government spending, financed by borrowing from the public Expansionary fiscal policy pushes the IS curve out, raising interest rates and limiting the amount of capital that is invested in the private sector Today, India appears to be adopting more conservative attitudes towards fiscal expenditures Healthy economic growth, stricter tax collection, and loan repayments by state governments should help to reduce the deficit (See figure 2) India’s current government has been following an expansionary monetary policy In 2002, interest rates reached their lowest since 1974 Interest rates were able to decline due to a period of low inflation However, in the near future the central bank of India may follow a contractionary monetary policy It may raise interest rates in the coming year to prevent inflation from rising In a situation with stable fiscal policy, raising interest rates is equivalent to restricting the money supply, or moving the LM inwards (See figures and 4) Aside from monetary policy, inflation in India is affected mainly by agricultural support prices and GDP growth Other major forces acting on inflation are increased competition in the manufacturing sector, which has reduced inflation, and an increase in the prices of fuels and raw materials, which increased inflation Inflation was 10% from 1992 to 1997 but only 4.9% in 2001/2002, and is expected to remain around 5% for the near future (See figure 6) Source: Confederation of Indian Industry India as a Transition Economy Transition economies, in order to succeed, need political stability, an export base, a coordinating device, property rights, and checks and balances such as a free press, elections, accountability, and multi-party political systems India has a transition economy in that it is changing from a closed, socialist state to a more open and liberalized system In the 50s, 60s, and 70s, the country championed import substitution and discouraged foreign direct investment Since the 80s and especially after the payments crisis in 1991, India has been moving towards a more open economy and has been privatizing many government owned corporations India has political stability, due to its plethora of political parties and long-standing democratic institutions The judiciary, the election commission, and the media are strong institutions in India that provide checks and balances Finally, the payments crisis in 1991 acted as a coordinating device, and has aligned the country’s multiply political parties around free market reforms and economic liberalization Three Key Issues: Privatization, Agricultural Productivity, and IT Outsourcing Privatization, agricultural productivity, and the information technology export sector will be important catalysts for future economic growth Privatization is paramount to increasing productivity and competitiveness, as well as attracting foreign direct investment Agricultural productivity is necessary to free up labor for more enriching economic activities, and for India to reach developed nation status The information technology export sector has already fueled much of India’s growth, and will grow in its importance as the rupee appreciates against the dollar and wages begin to rise Privatization On Saturday, March 20, 2004, I was part of a group of students from Sloan that met in Delhi with Dr Arun Shourie, India’s Minister for IT, Communications, and Disinvestment A major part of our discussion involved disinvestment, or privatization The Indian government, according to Dr Shourie, will not privatize companies in the atomic energy, defense, and railway sectors, or the largest companies dedicated to petroleum exploration and natural gas The government decides which firms to privatize based on the recommendations of the disinvestment commission, which assesses each of the 1000 publicly owned corporations Dr Shourie seemed somewhat frustrated with the speed with which the government was instituting reforms, and alluded to the fragmented interest groups and political factions as a cause of the lethargic pace of progress The public sector is extremely inefficient when compared to the private sector, and its large size makes it an obstacle to growth In India, the state employs 70% of the 28 million workers in organized employment In addition, the private sector would benefit greatly from further liberalization and less government control However, as corroborated by the opinion of Dr Shourie, many reforms have been delayed or cancelled due to vested interest by many in the status quo In particular, labor unions are powerful and have strongly opposed labor reforms (See figure 7) Agricultural Productivity Roughly two thirds of the workforce in India is employed in the agricultural sector, and the majority of these workers are subsistence farmers Despite its prominence in total number of employees, agriculture accounts for only 25% of GDP Productivity is extremely low and the vast majority of farmers depend on the monsoon for a healthy crop Only 1/3rd of all cropland is irrigated, and few farmers have consistent access to fertilizers, irrigation, or high-quality seeds One fourth of public investment is in agriculture, and this number will increase if a new large scale government project to link many of India’s rivers is implemented Government initiatives to increase productivity, such as the Green Revolution, have proved effective mostly for the wealthier farmers, who comprise 10% of farm households but own 53% of farmland The Green Revolution involved the dissemination of highyield crop varieties and advanced fertilization and irrigation techniques Government involvement in the agricultural sector has also prevented increases in farm productivity The government sets minimum support prices for food grains and enforces these prices by purchasing part of the crop yield This has caused the governments food stores to exceed its storage capacity and has raised the prices of food grains to artificially high levels High support prices give farmers little incentive to efficiently allocate their crop production according to market demand, or to produce a larger variety of crops Since domestic demand is artificially high for certain crops such as sugar, cotton, just, vegetable oil, tea, and coffee,) farmers have neglected potentially lucrative export markets in other crops such as rice, cotton, fruit, and flowers Information Technology Outsourcing India has emerged as a leader in information technology services and advanced research and development Although this is surprising for a developing country, India’s strengths in IT services are a natural outgrowth of the country’s competitive advantages India’s institutions of higher education produce the world’s second largest pool of scientists and engineers (behind the US.) Additionally, these professionals are relatively inexpensive to hire, costing ẵ to ẳ that of an American software engineer Due to its previous status as an English colony, English is widely spoken, especially among the educated classes The Indian software industry started to develop after IBM left India in 1977 because of policy differences with the government Tata Consulting and other local companies sought to fill the void by providing low end export services to multinationals These low end services comprised activities such as maintenance of legacy systems, programming and testing for the Y2K millennium bug, and Euro conversion Indians educated in the United States facilitated the development of India’s IT sector, as many moved back to India and accelerated the learning curve of local software companies Other Indians who stayed in the United States were able to strengthen relationships between new Indian software firms and American multinationals Also, declining prices for data communications infrastructure and computer hardware, combined with lower import tariffs in the 1990s, lowered the barriers to entry for new companies and increased the range of services available for outsourcing Many Indian companies that began with low end services now specialize in more sophisticated IT services such as business process outsourcing, primary research and development, and engineering design Global companies such as Lucent, Hewlett-Packard, IBM, Microsoft, Cisco, and Eli Lilly are also establishing operations in India GE’s largest R&D lab, which employs 2600 scientists, is in India in the city of Bangalore As a testament to India’s sharp learning curve in IT services, the country is home to over half of all software companies to have achieved Carnegie Mellon University’s prestigious CMM Level-5 rating The IT sector’s growth has been equally impressive as its learning curve By 2000, over 200 of the fortune 1000 companies were outsourcing software development to India In the same year, IT outsourcing had grown to 20% of India’s export revenues, and services exports were larger than the combined exports from the country’s two largest manufactured goods industries (textiles/garments and gems/jewelry.) IT services had grown an average of 46% per year since 1993 and has remained an export industry: foreign demand accounts for 80% of total production The United States alone receives 60% of India’s software exports By 2008, the services industry in India is predicted to reach $87 billion, including $50 billion in exports Also in 2008, Indian services companies are predicted to number 400 and command a market capitalization of US$225 billion These predictions would place India’s share of the US software market in 2008 at a modest 4.1% Although India’s dual BBNNs may appear similar to China’s BBNNs, there is one important difference Growth in China’s private sector BBNN is related to the increase in manufacturing in China, which creates a lot of jobs Growth in India’s private sector BBNN can be attributed largely to the successes of information technology outsourcing Dr Shourie pointed out that India’s IT industry, as well as other promising Indian industries such as pharmaceuticals, biotechnology, and nanotechnology, generate publicity and income but not create large numbers of jobs This has a few implications for future growth Eventually, China will have to transition from a manufacturing economy to more sophisticated industries India will already have competencies in high tech and will only need to grow these sectors as it develops However, early development of high tech may cause problems of income distribution Dr Ravi Ramamurti, in his speech at Sloan on the 23rd of February, 2004, predicted that the growth of the IT sector in India would widen the income gap between the rich and the poor Large income differentials often affect social peace, and may cause civil unrest In addition to promoting high tech industries, India will have to develop industries with the potential for large scale job creation in order to eradicate poverty and maintain social peace A Prescription for Future Growth As reflected by its GDP growth, India has been following sound economic policies since 1991 These policies should continue, although some could be refined or enhanced, and new policies should be undertaken to insure continued economic growth in the future Specifically, India should institute faster privatization (if possible,) including privatizing industries that the government has excluded from disinvestment plans, increase agricultural productivity and ease the transition of subsistence farmers into the national economy, and continue infrastructure development and promotion of IT and other high tech sectors Privatization and increased agricultural productivity will have an immediate effect of increasing the labor pool, which will increase the level of unemployment However, as long as the economy is growing, new jobs will soon be available to displaced public sector employees and farmers These new jobs will be better and more productive than the public sector positions previously available Employment will flow to where it will be most efficiently used, thus feeding a virtuous cycle of job creation and raising the government’s tax base Also, selling public corporations will increase government revenues and help to reduce the fiscal deficit, as long as fiscal expenditures are relatively conservative A flood of new workers into the workforce will put pressure on wages to decrease, if all other factors are held constant This may be good for the Indian economy because the rupee has been appreciating, making the economy as a whole less competitive An appreciating currency is not good for a transition economy since there is latent unemployment due to excess employment in the underperforming public sector Job creation is easier when exports are more competitively priced Although the speed of privatization should increase, it should not happen all at once Sudden massive unemployment would not be palatable for many citizens and could create social unrest A portion of the additional income generated through privatization should be spent on infrastructure projects and other programs aimed at increasing agricultural productivity Increased agricultural productivity can be achieved through education, increased use of technology, better infrastructure, and less government involvement in produce markets Government participation in agricultural markets should be limited to promoting renewable energy and reducing both pollution and India’s dependence on foreign oil Dr Shourie advocated government subsidies for growing oil rich seeds that can be used to produce energy Support prices should be gradually eliminated, which will have the added benefit of allowing farmers to produce agricultural goods for profitable export markets In addition, specialization and larger farm sizes will facilitate an increase in productivity As infrastructure improves, new economic activities will be possible, trade will increase, and companies will become more efficient An increase in agricultural productivity will cause the relocation of many subsistence and small scale farmers to other industries in rural and urban settings New job creation due to improved infrastructure will become available to the displaced farmers, who would eventually achieve a better standard of living and contribute more to the growth of the Indian economy (See figure 8) India has benefited greatly from its promotion of the IT sector Business process outsourcing, engineering design, call centers, and other similar industries are well suited to take advantage of India’s robust telecommunications and data processing networks Bangalore and Hyderabad, both cities in southern India, have experienced tremendous successes with the growth of software and other skill intensive industries The government’s role in this growth has been positive, by easing regulations and by investing in advanced telecommunications infrastructure This infrastructure, while much less costly, has achieved similar economic goals as building more traditional infrastructure such as railways and ports Promotion of IT and other high tech sectors should continue and included areas such as pharmaceuticals, biotechnology, and nanotechnology If India is to sustain growth, its services sector should look to build competitive advantages that are not dependent on cost arbitrage, as this may disappear in the future India should focus on leveraging skills and talent and producing cutting edge technology to prepare itself for future competition as a first world economic power These policies, if successful, would further alter India’s economic landscape and produce changes that can be easily illustrated by the BBNN As productivity increases in the agricultural sector, migration to the cities will increase, further pushing the NN outward and raising the level of unemployment Non agricultural economic activity must continue to grow to absorb these workers Increased productivity in agriculture may also provide an economic stimulus to small towns by allowing subsistence farmers to concentrate on other activities The rupee would maintain its position relative to the dollar, despite impressive and sustained growth in IT and other high tech sectors Growth in these industries would be helped by the stable exchange rate A stable rupee would also give high tech companies time to develop strong competitive advantages in preparation for the future appreciation of the rupee and a less forgiving competitive landscape In the small towns, migration to the cities and productivity increases in agriculture will result in the small town BBNN depicted below Population decreases, output increases slightly, and incomes increase significantly (See figure 9) Even if these policies are successful, it may take 20 to 30 years before the real natural rate of unemployment is reached and the rupee begins to appreciate The numbers of workers who must transition from public companies and agriculture to industry in the private sector is overwhelming Two thirds of the work force is employed in agriculture, and 70% of the remaining workers (in organized employment) are employed by the government If these numbers are correct, 80% percent of the organized workforce would need to transition to private sector industry (given that 10% of the workforce remains in agriculture.) The biggest risk from increased productivity in the agricultural sector is that job creation in industry and in the cities will not keep up with the increasing supply of labor Another risk is that total agricultural production will decline Agricultural productivity will need to rise at least as quickly as the transition from agriculture to industry takes place For example, if productivity rises 4% per year, 4% of the agricultural workforce can find jobs outside of farming every year, while maintaining prices and output stable In actuality, productivity may rise faster than the industry transition, since rising incomes will most likely increase demand for agricultural products India has seen impressive rates of growth in the last 13 years If it continues its policies of economic liberalization and privatization, it may eradicate extreme poverty among its people within the next twenty or thirty years India is poised to contribute significantly to advances in science and technology, and its development will benefit not just India, but the entire world 10 Appendix: Graphs and Charts Figure Figure Source: Confederation of Indian Industry 11 Figure Source: Global Financial Data Inc Figure 12 Figure Source: Confederation of Indian Industry Figure Source: Global Financial Data Inc 13 Figure Figure 14 Figure 15 Bibliography The Economist Intelligence Unit April 2004 Country Report – India The Economist Intelligence Unit April 2004 Country Profile – India The Economist Intelligence Unit April 2004 Country Commerce – India Report for Congress - Received through the CRS Web, Developing Countries: Definitions, Concepts and Comparisons, December 6, 2002 Jonathan E Sanford, Specialist in International, Political, Economy, Foreign Affairs, Defense, and Trade Division Anjula Sandhu, Research Associate, Foreign Affairs, Defense and Trade Division Congressional Research Service ˜ The Library of Congress Devesh Kapur and Ravi Ramamurti, “India’s Emerging Competitive Advantage in Services” Meeting with Dr Arun Shourie, New Delhi, India, March 20, 2004 Concepts from the textbook, Macroeconomics, 3rd Edition, Blanchard, 2002 Confederation of Indian Industry: www.ciionline.org India Brand Equity Foundation: www.ibef.org 16 ... illustrates India? ??s position on the BBNN and ISLM, and within a framework for understanding transition economies Finally, the paper outlines a strategy for continued growth and development The Indian... necessary to free up labor for more enriching economic activities, and for India to reach developed nation status The information technology export sector has already fueled much of India? ??s growth, and... Information Technology Outsourcing India has emerged as a leader in information technology services and advanced research and development Although this is surprising for a developing country, India? ??s