Friday, 1 March 2013

Resurgence of 1991 reforms in India

Indian economy has witnessed major reforms in the year 1991 which include-liberalization of foreign trade, abolishment of industrial license system and opening up of foreign direct investment. The growth witnessed by Indian economy after 1991 can be attributed majorly to these reforms. However, the current scenario is quite gloomy with a GDP growth of 6.9%, fiscal deficit of 5.7% of the GDP and credit rating of negative BBB-. In the wake of such turbulent situation, Indian Government has introduced various reforms recently which include:
  • FDI in Retail Sector
  • Removal of subsidies on diesel and cooking gas.
  • FDI in Civil Aviation Sector
  •  FDI in Financial Sector  
Macroeconomic implications of each of these reforms on various sectors of Indian Economy, in the short and long run, has also been presented in this article.

FDI in Retail:
Retail Market in India is one of the fastest growing retail markets contributing 14 to 15% of the GDP of Indian Economy. As per the new FDI policy 51% investment in multi brand retail is allowed with half investment in backend infrastructure and 30% sourcing from local players as mandatory policies.
FDI in retail will encourage local players to invest in the remaining 49% stake and form joint ventures with the foreign players. The improvement in storage facilities brought by the foreign players will reduce the food wastage of farmers (currently 40% of the total produce). This will reduce the selling costs of the farmers who will be willing to be produce more. Wages of employed farmers will also rise because of the increase in demand to produce more. Small land holding farmers who cannot produce beyond a certain capacity will be employed by large land holders at better wages thereby making this reform benefit the rural society as a whole in the long run.
Multinationals will facilitate smooth international trade which will lead to an inundate flow of low priced imports to Indian markets. Small and Medium manufacturing units in India will suffer because of this in the short run. FDI in retail will also disrupt the price quantity relationship of the demand curve. When quantities are low, farmers cannot expect better prices as they cannot influence foreign prices leading to great fluctuations in their income levels. Also, in the long run the investments from foreign players will phase out and imports will continue which might lead to balance of payment crisis as well.
Therefore, in order to leverage the best from this policy, government has to ensure that FDI in Retail in India takes the current infrastructure to a new high level, improve the supply side demand and thereby lead to an increase in overall output of the economy rather than improving mere trade relationships.

Removal of Diesel Subsidy-Impact on Indian Economy:
Rise in Diesel prices is targeted to reduce the high fiscal deficit accumulated by the Indian Government. There has been an outcry in the society that this policy will lead to high inflation. On the contrary to this popular notion, diesel subsidy will cause inflation in the long run which is as explained below:
The accumulated under recovery of Rs. 200, 000 crores of the oil marketing companies is funded by increasing the M3 component of money supply. This leads to ‘too much money is chasing too few goods phenomenon’, leading to rise in inflation. Central Bank cannot put control on this money supply as it further squeezes the funds available for other companies thereby leading to recession. Also, countries  which do not provide subsidies have low levels of inflation E.g. is 1.76% in U.S, 1.9% in Germany, -0.2% in Japan, 2% in China and 2.8% in Philippines. All these reasons prove that diesel subsidy is more detrimental to the society in the long run than rise in prices.
However, the impact of rise in diesel prices will increase the expenditure of farmers on diesel pump sets. This can be handled through targeted subsidy which can also be achieved through conditional cash transfers.
Thus, a rise in diesel prices though inflationary for India in the short run, will help in reducing its fiscal deficit to a great extent. Also, as industries migrate to other sources of energy, this will further enhance in better distribution of resources. The GDP rises because of removal of pointless subsidies, leading to increase in jobs and opportunities, thereby improving the production overall.

FDI in Insurance and Pension fund sector
Foreign Direct Investment is allowed in this sector as this is one of the largest reservoirs of infrastructure funds needed by the country currently. By allowing FDI in pension fund, private sector employees and self employed will get more options of pension products-most of who do not have viable pension savings option currently. This will pull more funds from the public which can be channelized into infrastructure projects. But, Government of India should ensure that there is strict regulation for pension sector even after the entry of foreign players. This will ensure the government to achieve its objective of long term growth without any collapse of the system.
The bad pricing structure currently being followed in the General Insurance Sector can be mended by the entry of foreign players. Those players of Life Insurance who are not well established or those who have ventured newly into this sector will also benefit from the process improvements by foreign players. The huge growth (40% in past six years) and low penetration (4% of Indian GDP) will let foreign players explore this opportunity by bringing diversified products from their expertise to this sector. This will boost public participation which will further improve the funds that will flow to this sector and increase overall contribution to India’s GDP of this sector.
(Note: According to insurance regulator IRDA, foreign participation will help this sector contribute 10-11% of our nation’s GDP.)

FDI in Civil Aviation:
Similar to the case of FDI in Retail, FDI in Civil Aviation will benefit the industry in the long run. In the long run it will help in adding extra capacity, strengthen the existing supply chain and thereby improve the operational efficiency of the industry. This will in turn lead to better profit margins. But, the current problem being faced by the industry is of profitability. This is mainly because of the huge fuel tax the domestic airline players have to pay to the government. The tax paid by the industry is 45% higher than other players of foreign market. Thus FDI might be beneficial in the long run, but not for short term profitable gains. The profitability can be achieved by changing the domestic Tax Policies.

From the analysis of the implications of the recently introduced reforms in India, we can conclude that FDI in Retail, Insurance and Pension fund sector are targeted in the right direction. Removal of diesel subsidy is also one of the major reforms taken by Indian Government to reduce the fiscal deficit. All these reforms have sent positive signals to the investor circle that India is willing to support foreign investors. If implemented with right regulations and proper checks and balances as suggested above, these reforms will be very fruitful in bringing back Indian economy back to the required growth track.


Written By
Soumya Ch.
IIM Raipur (PGP 2012-14)


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