Macro-Economic dimensions and Policy framework
Growth and Investment Targets || Domestic Resources for the Plan || Sustainable Current Account Deficit and External Resources || Structure of Growth and the ICOR || Fiscal Balance, Inflation and the Monetary Stance || Issues in Aggregate Demand Management || Sectoral and Investment Pattern || Strategy for agricultural Development || Infrastructure and Basic Industries || The External Sector and International Dimensions || Issues in Finance Intermediation

Issues in Aggregate Demand Management

2.82 All the Five Year Plans since inception have been based on the implicit, and often explicit, assumption of a binding savings constraint in the Indian economy. In other words, it has been assumed that aggregate investment demand in the country would consistently exceed the availability of investible resources. There is no simple and intuitively appealing method of empirically assessing the degree to which the different constraints are binding on the economy. Nevertheless, cognisance must be taken of the possibility that there may be situations when constraints other than savings are more relevant for determining the growth performance of the economy. The alternatives to the savings or investible resource constraint are : (a) the fiscal constraint, or the availability of sufficient resources with the government to meet the development objectives in a fiscally sustainable manner; (b) the foreign exchange constraint, or the availability of adequate foreign exchange for ensuring balance of payments sustainability; (c) the agricultural constraint, which arises from the insufficiency of ‘wage goods’ on the one hand, and the lack of a widely dispersed distribution of purchasing power, on the other; and (d) the infrastructural constraint, which arises from the lack of adequate infrastructure for sustaining high levels of capacity utilisation in the rest of the economy. These are generally referred to as ‘structural’ constraints, in the sense that they originate from rigidities in specific sectors. This is in contrast to the overall indication of the demand-supply position given by the savings constraint. This distinction between the structural constraints and the savings constraint has a crucial bearing on the conduct of policy.

2.83 In a structurally constrained economy, the very fact that the savings-constrained growth rate is greater than the attainable implies that the investment necessary to attain the maximum structurally constrained growth rate must be less than the ex-ante savings. This possibility may become a particularly serious problem when the public sector may no longer be the dominant investor, since public sector investment is by and large a policy decision, while private investment is very sensitive to behavioural parameters like capacity utilisation, or costs and prices being expected to be influenced by other structural constraints. Earlier, even private investments were not particularly sensitive to such variables since the industrial licensing regime offered sufficient quasi-monopoly powers to off set their adverse effects, at least for some time. At present, with the shift towards greater market-orientation of the economy, where private sector investments are expected to be large and account for more than 65 per cent of total investment and the extent of competition to be significantly higher, private investors are unlikely to tolerate increasing capacity underutilisation that may result from such constraints, and will tend to adjust their planned investments accordingly. Thus, a generalised aggregate demand problem can arise whereby the actual demand-constrained growth rate will fall short not only of the level justified by the available investible resources or ex-ante savings, but also of the structurally constrained one. In such a situation, public investment becomes crucial which can, by policy, be guided to reduce the structural bottlenecks, and avoid problems arising out of transient movements in current aggregate demand.

2.84 Although the identification of what exactly is the binding constraint to growth is difficult to demonstrate with quantitative precision, it is possible to show that with the current availability of resources, the Indian economy could have a higher rate of investment, and therefore a higher rate of growth, had the policies succeeded in removing the specific bottlenecks or structural constraints. In other words, savings or investible resources have not always been the binding constraint. Indeed. the persistent difference between the total external capital inflows and the current account deficit (CAD) is a fairly sensitive measure of the extent of excess resource availability which could have been used to raise the rate of investment and the rate of growth. Since the initiation of economic reforms in 1991 and the liberalisation of foreign investments, such a situation has obtained persistently during the Eighth Plan period. The extent of absorption of external capital flows in the real economy during the Eighth Plan period is presented in Table 2-22. It can be seen that during the Eighth Plan the economy was unable to productively utilise the entire amount of investible resources that became available. Indeed, even the foreign investment flows were not fully absorbed in the form of physical resources. Instead of financing larger import surpluses or inflow of physical resources, these capital flows led to a substantial increase in foreign exchange reserves. While there was certainly a need to restrain excessive increases in domestic demand in order to re-build the country’s foreign exchange reserves which had become excessively depleted in 1991-92, this need was more or less over by the end of 1993-94, by which time the foreign exchange reserves stood at over US $ 19 billion. The situation would have appeared even worse but for the fact that the Government had placed binding ceilings on external commercial borrowings (ECBs) and had periodically implemented measures to regulate the inflow of foreign portfolio investment (FPI).

                        Table 2-22 : Absorption of External Resources
				 (per cent of GDP)
------------------------------------------------------------
               CAD    Capital     Foreign     FE Reserves
                      Inflows   Investment (months of imports)
------------------------------------------------------------
1992-93       1.57     1.79         0.12        4.8
1993-94       0.33     3.76         1.64       10.2
1994-95       0.84     3.01         1.58        8.4
1995-96       1.63     1.42         1.42        6.0
1996-97       1.13     2.97         1.51        6.9
Eighth Plan 
Average       1.1      2.58         1.32        7.3
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2.85 The incomplete utilisation of the available investible resources during the Eighth Plan needs to be seen in the context of the considerable liberalisation of private investment that has taken place during this period. The almost complete abolition of industrial licensing, relaxation of FERA and MRTP restrictions, opening up of the sectors which had earlier been reserved for the public sector, all had contributed to an unprecedented increase in private investment opportunities. On the face of it, the private sector did respond positively to these policy measures, in that the average growth rate of private investment during the Eighth Plan was 14.4 per cent per annum, more than double that of any period in the past. These figures are, however, conditioned by the low level of investment in the base year (1991-92), when private investment had actually dropped by 22.0 per cent. Correcting for this base year problem, the rate of growth of private investment comes down to 7.2 per cent, which is still significantly higher than the trend rate of 6.5 per cent witnessed during the 1980s. However, the contrast of this with public investment is striking. Whereas the pace of private investment depends on many market uncertainties and slow build-up of confidence, tardy growth of public investment would be indicative of the failure of planning, inability to transfer investible resources to the public sector and use them to remove the binding bottlenecks. The growth rates of investment during the Eighth Plan and proposed for the Ninth Plan are given in Table 2-23. It will be seen that the Ninth Plan investment programme envisages a slower rate of growth of private investment than was experienced during the Eighth Plan despite a higher growth rate of total investment and a much higher growth of public investment. This feature of the Ninth Plan needs explanation.

                            Table 2-23 : Growth Rates of Investment       
                                                                         (percent per annum)
-------------------------------------------------------------
                  Trend Rate	   Eighth Plan    Ninth Plan
 				 ----------------
                   (1980-90)    Actual Corrected  
                   ---------    ------ ---------  ----------
Total Investment      6.4       10.3      5.9        7.3
Public Investment     6.3        2.5      2.5       11.5
Private Investment    6.5       14.4      7.2        5.5
-------------------------------------------------------------

2.86 First, all indications point to the likelihood that the Indian economy would have access to a larger volume of resources and should be able to absorb a much higher rate of investment during the Ninth Plan period. The recent slow-down in the economy appears to indicate that an aggregate demand problem arising from one or more of the structural constraints is leading to excess capacity and accumulation of stocks, and the economy is likely to behave in a cyclical manner unless the Government intervenes and these constraints are removed. In view of the recent behaviour in external capital flows, the foreign exchange constraint does not appear to pose a problem for the immediate future. On the contrary, unless it is regulated to a certain extent as discussed earlier, there may be excessive inflows which may create problems of its own, particularly as far as the Government’s fiscal position and exchange rate management are concerned. Both of these impinge on the attainment of the targetted growth rate of exports which needs to be maintained so that foreign exchange problems do not re-emerge when the servicing payments on the current foreign investments start to accelerate. Agriculture too does not appear to be a primary constraint given its performance in recent years. In fact, if the Ninth Plan targets for agriculture are attained, it should instead provide an additional impetus to investment and growth during the Ninth Plan period. This will, however, require adequate public investment, which underlines the need to adhere to the planned public investment programme, particularly by the States.

2.87 The main areas of concern, therefore, are the fiscal and the infrastructural constraints, which are closely linked in the present circumstances where the bulk of investment in infrastructure will continue to be in the public domain. The model results indicate that public investment has fallen to a level such that private investment demand cannot rise sufficiently to compensate. As a result, there is an inadequacy of aggregate demand arising out of insufficient public investment, and an increase in public investment will not "crowd out" private investment at least in the near future, and may indeed lead to a certain degree of "crowding in". Moreover, infrastructural inadequacies are starting to be felt in a serious manner, and unless these are overcome expeditiously, private investments will continue to be sluggish. Although vigorous efforts should continue to be made to encourage private investment in infrastructure, the present state of preparedness is such that not too much can be expected in physical terms within the Ninth Plan period. The bulk of the responsibility, therefore, will have to continue to rest with the public sector which has sufficient existing assets to build upon through expansion, upgradation and modernisation. Therefore, the Ninth Plan should be seen as a phase of consolidation whereby the conditions are created for a more vibrant and sustained growth of the private sector in the future.

2.88 Second, private investments during the Eighth Plan were fuelled by an unprecedentedly high rate of growth of credit to the private sector, which accelerated from the long-run average of about 6.5 per cent per annum in real terms to above 8.5 per cent. This was partly the outcome of the reduction in pre-emption of credit by the public sector and partly from the financial sector reforms whereby the reserve requirements of the banking sector were reduced substantially, on the one hand, and the role of the non-bank financial sector increased significantly, on the other. This latter effect is unlikely to obtain to quite the same extent in the Ninth Plan since much of the correction has already been accomplished and credit expansion is likely to settle down to a more stable growth path dictated by the overall monetary policy stance.

2.89 Keeping the above factors in mind, the likely behaviour of private investment has been estimated and projected for the Ninth Plan period. Although the effect of the infrastructural constraints have not been captured meaningfully, the role of growth expectations and credit availability in determining private investment demand are significant. The projections show that if real credit to the private sector is allowed to grow at the trend rate of 6.5 per cent per annum and if public investments are as per the Plan, the total investment rate in the economy is likely to rise by about one percentage point over the Ninth Plan target. While this will enable the economy to step up the average growth rate of GDP from 6.5 to 6.8 per cent per annum, the current account deficit will rise to 2.6 per cent of GDP, which would be higher than the sustainable limits described earlier unless there is a substantial growth in foreign direct investment to finance it. Considering the very low share of India in the total flow of FDI in the world, it may be quite possible for India to attract that order of foreign direct investment. Indeed, an effect of increased FDI may be to raise the average productivity of capital and lower the ICOR.

2.90 On the other hand, if the CAD tends to rise beyond the sustainable limits without commensurate increase in FDI, corrective measures may have to be taken. It should be recalled, however, that the sustainable level of CAD has been computed on the basis of the entire external inflows being in the form of debt. Therefore, a CAD of this order can be maintained with greater recourse to external debt, provided that these are mainly in the form of medium to long-term ECBs and not in short term debt. This implies that the Ninth Plan targets can be achieved even with insufficient FDI through flexible use of the ECB limits, and there is no compelling reason to reduce public investment for balance of payments reasons unless both the CAD threatens to pierce the limit and FDI does not materialise in adequate measure. In such a situation, in order to maintain the projected macro-parameters of the Ninth Plan and retain the growth target of 6.5 per cent, public investment could have to be less by 1.1 percentage points of GDP from the planned in order to accommodate the additional private investment. A comparative picture of the macro-economic parameters of these three scenarios is presented in Table 2-24.

                            Table 2-24 : Macro Parameters in Alternate Scenarios
 -----------------------------------------------------------
                                  Plan     Scen-I   Scen-II
 -----------------------------------------------------------
  1. Domestic Savings Rate        26.1      26.5      26.1
     (% of GDP at market price)
  2. Current Account Deficit       2.1       2.6       2.1
     (% of GDP at market price)
  3. Investment Rate              28.2      29.1      28.2
     (% of GDP at market price)
         3a. Public                9.4       9.6       8.3
         3b. Private              18.8      19.5      19.9
  4. ICOR                          4.3       4.3       4.3
  5. GDP Growth Rate               6.5       6.8       6.5
     (% Per Annum)
  6. Export Growth Rate           11.8      11.8      11.8
     (% Per Annum)
  7. Import Growth Rate           10.8      11.7      10.8
     (% Per Annum)
------------------------------------------------------------

2.91 Although Scenario-II appears attractive from the point of view of its implication for the government’s fiscal deficit as compared to the Plan, it involves certain serious risks which have to be noted. First, there is no assurance that the projected private investment will actually materialise since the negative effects of the existing infrastructural shortages have not been adequately captured in the private investment demand function. If it does not, since public investment is fixed ex-ante by the Plan, the total investment will fall by a multiplier process and the growth rate will suffer quite seriously. Such a reduction in the total aggregate demand tends to fall more heavily on the agricultural sector, which is likely to experience a deterioration in its terms of trade. As a consequence, agricultural growth will inevitably suffer both from the supply side, as investment by both the public and private sectors will fall relative to the planned, and also from the demand side, with a downward pressure on relative prices. Any reduction in the growth rate of agriculture will not only make it more difficult to attain the other objectives of the Ninth Plan, but it will also have serious long-run implications for sustainability of the growth path and the objective of food security.

2.92 Another reason why the projected private investment may not materialise in its entirety lies in certain weaknesses that are becoming increasingly perceptible in the Indian financial sector. As the Indian private sector moves towards investment in the more capital-intensive and longer gestation projects in the infrastructure and heavy industry sectors, its needs for long-term funds, both equity and debt, will increase rapidly. The financial sector is presently not structured to cater to these demands in an adequate manner. The long-term private debt market is practically non-existent in India, and has to be created almost ab-initio. The equity market too is extremely weak, both in its ability to mobilise sufficient resources and to generate adequate investor confidence in new issues. The investment boom observed during the Eighth Plan rode on the expansion plans of the existing large corporate bodies. There is, however, a limit to the absorptive capacity of such corporations, and a sustained growth in private investment cannot come about without new and relatively unknown companies coming into the equity market. Even short- and medium-term debt is becoming problematic for the smaller and financially weaker companies as the banks are turning more sensitive to their level of risk exposure. These issues will have to be addressed during the Ninth Plan, and are discussed later, but until they are resolved satisfactorily, a certain degree of doubt exists about the potential private investment demand growth during the Ninth Plan.

2.93 Second, even if private investment demand is assumed to grow at the rate required by Scenario-II, at least a part of the reduction in public investment will inevitably fall on economic infrastructure, as has been the experience in the past. If the increase in private investment in infrastructure does not compensate for this decline in public infrastructural investment, the relative availability of infrastructure will become even worse than it is at present, and will seriously jeopardise future growth prospects. Under the circumstances, it is therefore preferable to target the higher level of public investment, particularly since the fiscal position of the government can be quite sustainable as has been indicated earlier.

2.94 On the other hand, the Plan carries the danger that if private investment is left unconstrained, then there may be excessive pressure on the credit front. This needs to be seen in the context of a fairly tight growth rate of money supply that is desirable in order to contain inflationary pressures and a need to reduce the nominal interest rates, particularly on public debt. Excessive credit demand originating from a targetted public sector borrowing requirement and a higher than expected private investment demand can be met upto a point by an increase in the credit to base money ratio or the broad money multiplier without increase in the interest rate. However, it would have implications regarding the inflationary pressures on the economy since the growth rate of broad money would be above the target range. Beyond that level, however, interest rates too are bound to increase, which would not only jeopardise the fiscal sustainability target but also increase the inflationary tendencies through a cost-push effect in addition to the demand-pull effect of the growth of broad money. In order to obviate this possibility, deliberate measures to contain private investment may have to be instituted. The modality to achieve this would be to restrict the growth rate of credit to the private sector to slightly above the level required to achieve the desired level of private investment. According to the estimated private investment demand function, this would mean that real credit growth to the private sector will have to be no more than 5.5 per cent per annum, as compared to the trend rate of 6.5 per cent. With inflation in the range of 5 to 7 per cent, this translates to a growth in nominal credit in the range of 10.5 to 12.5 per cent.

2.95 A possible alternative to deliberate credit control for achieving the objective of limiting private investment would be to engage in an aggressive programme of disinvestment of selected PSEs and encouraging formation of joint ventures and other forms of public-private partnership. Disinvestment or divestment of existing PSEs absorbs credit without creating new investment demand provided that the proceeds are appropriated to the consolidated funds of the government. Joint ventures, on the other hand, do create new productive assets, and thereby adds to investment demand, but these can be adjusted within the overall limits specified in the Plan for investment by the public sector enterprises and thereby reducing the public sector borrowing requirements (PSBR). A distinction, however, has to be drawn between raising disinvestment or joint venture equity funds from the domestic market and in foreign markets. The former is a drawal on the overall investible resources of the economy and therefore reduces the resources available for private investment pari-passu. The latter represents an addition to total investible resources and therefore does not serve the purpose of controlling private investment, although it does add to the productive capacity of the economy. Further, there is a question regarding the ability of the public sector, particularly the States and the PSEs, to raise the necessary investible resources from the market in order to undertake their planned investment programme. Failure on this count will expose the economy to the same risks that have been mentioned in connection with insufficient private investment demand. With the statutory liquidity ratio (SLR) having become non-credible as an instrument for raising public debt resources, alternative methods will have to be sought. The first step, of course, is to enhance the creditworthiness of these agencies and perhaps increase the extent of Central Government intermediation, as have been mentioned earlier. Public-private partnerships can also contribute to this process. But these may be insufficient, particularly for State government borrowings. There may be a case for State governments to issue specific-purpose debt instruments which are linked to particular projects rather than general claims on the State exchequer. If such initiatives can be made sufficiently attractive, it would obviate the need to deliberately curtail the rate of growth of overall credit availability.

2.96 If, however, public investment comes under pressure due to a shortfall in the attainment of the public savings target, the response would have to be different. Much would depend upon the source of the shortfall. If it occurs due to the inability of the government to either raise its tax revenues or curtail its growth of revenue expenditures as planned, the overall availability of domestic savings may not be affected substantially since the disposable income of the private sector will rise and thereby increase private savings at least to some extent. In such a situation, a combination of a higher than planned investment by the Centre, which does have a certain degree of fiscal cushion, and a more liberal credit regime for private investment may serve the purpose, particularly if these investments can be guided into the infrastructure sectors. If, however, the shortfall occurs mainly on account of a reduction in the savings of the public sector enterprises, it may lead to a decrease in the domestic savings rate. Efforts to compensate by increasing private investment may not be appropriate in such a situation since it can lead to over-heating of the economy and an unsustainable balance of payments position. Private investment can be allowed to increase only to the extent they are financed by foreign savings, particularly FDI.

2.97 The combination of these various alternatives which can be effectively implemented would have to be determined from time to time depending upon the emerging situation and the constraints faced by the different agencies involved. However, it needs to be emphasised that unconstrained increase in private credit will expose the economy to needless risks and due care will have to be exercised in managing the behaviour of aggregate demand in the economy. A process of continuous monitoring of the various critical parameters of the Ninth Plan will have to be instituted and a mechanism to incorporate such information in the process of Annual Plan formulation in a flexible manner will need to be effected.