Trade Liberalization Since 1991

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TRADE LIBERALIZATION SINCE 1991

TRADE LIBERALIZATION SINCE 1991 Import controls in India were originally imposed in May 1940 to conserve foreign exchange and shipping for World War II. But starting in 1947, regulation of the balance of payments became the central concern of the Indian government, which introduced restrictions on the rate at which foreign exchange could be depleted. From then on, India alternated between liberalization and tighter controls, until the beginning of the launch of the first Five-Year Plan. The period during that first plan, covering 1951–1952 to 1955–1956, was one of progressive liberalization.

A balance-of-payments crisis in 1956–1957 led to a major policy reversal. India restored its comprehensive import controls, which remained in place until 1966. In June 1966, under pressure from the World Bank, it devalued the rupee from 4.7 rupees to 7.5 rupees per dollar, and took steps toward liberalizing import licensing and lowering import duties and export subsidies. But intense domestic reaction to the devaluation led to reversal of the policy within a year, and import controls were again tightened. By the mid-1970s, India's trade regime had become so repressive that the share of nonoil and non-cereal imports in the Gross Domestic Product (GDP) fell from the already low 7 percent in 1957–1958 to an even lower level of 3 percent in 1975–1976.

In the late 1970s, two factors paved the way for yet another phase of liberalization. First, industrialists came to feel the adverse effect of the tight import restrictions on their profitability and lobbied for liberalization of imports of raw materials and machinery that did not have domestically produced substitutes. Second, improved export performance and remittances from overseas workers in the Middle East in the post–oil-crisis era led to the accumulation of a healthy foreign-exchange reserve, raising the comfort level of policy makers with respect to the effect of liberalization on the balance of payments.

Liberalization and Growth in the 1980s

The liberalization process was initiated in 1976 through the reintroduction of the so-called Open General Licensing (OGL) list that had been part of the original wartime regime but had become defunct as controls were tightened in the wake of the 1966 devaluation. The OGL operated on a positive-list approach, whereby the item placed on the list no longer required a license from the Ministry of Commerce. This did not necessarily mean that imports of the item on the list were free; the importer usually had to be the actual user of the imports, and could be subject to clearance from the industrial-licensing authority in the case of machinery imports.

Upon its introduction in 1976, the OGL list contained only 79 items. But by April 1990, the list covered 1,339 items, approximately one-quarter of all tariff lines and more than 30 percent of all imports. Though tariff rates were raised substantially during this period, with items on OGL given large concessions on those rates through "exemptions," they did not significantly add to the restrictive effect of licensing. The government also introduced several export incentives, especially after 1985, which partially neutralized the anti-trade bias of import controls. Above all, from 1985 to 1990, the effective nominal exchange rate was depreciated by a hefty 45 percent, leading to a real depreciation of 30 percent.

These and other liberalization measures relating especially to industrial licensing, improved agricultural performance, discovery of oil and expansionary fiscal policy combined to raise the growth rate in India from its traditional, so-called Hindu rate of approximately 3.5 percent during the years 1950 to 1980 to 5.6 percent during the period from 1981 to 1991. The jump in the average annual growth rate was particularly significant from 1988 to 1991, when it reached 7.6 percent.

Nevertheless, the external and internal borrowing that supported fiscal expansion was unsustainable and culminated in a balance-of-payments crisis in June 1991. This time, however, the government turned the crisis into an opportunity, and instead of reversing the course of liberalization, launched a truly comprehensive, systematic, and systemic reform program that continues to be implemented. The Soviet collapse, China's phenomenal economic rise following its adoption of outward-oriented policies, and India's own experience—first with protectionist policies for three decades and then liberalization in the second half of 1980s—convinced policy makers of the merits of the new policy approach that had been advocated for years by pro-market and pro–free-trade economists, most prominently Jagdish Bhagwati.

Systemic Reforms Beginning in 1991

The trade liberalization program, initiated in July 1991, was comprehensive but gradual and remains under implementation. It is useful first to consider the measures taken in the areas of trade in goods and services and then to discuss their impact.

Merchandise trade liberalization

The 1991 reforms did away with import licensing on virtually all intermediate inputs and capital goods. But consumer goods, accounting for approximately 30 percent of the tariff lines, remained under licensing. It was only after a successful challenge by India's trading partners in the Dispute Settlement Body of the World Trade Organization (WTO) that these goods were freed of licensing a decade later, starting 1 April 2001. Since that time—except for a handful of goods disallowed on environmental, health, and safety grounds, and a few others that are canalized (meaning they can be imported only by the government), including fertilizer, cereals, edible oils, and petroleum products—all goods can be imported without a license or other restrictions.

Tariff rates in India had been raised substantially during the 1980s to turn quota rents into revenue. For example, according to the Government of India (1993), tariff revenue as a proportion of imports went up from 20 percent in 1980–1981 to 44 percent in 1989–1990. According to the WTO (1998), in 1990–1991, the highest tariff rate stood at 355 percent, the simple average of all tariff rates standing at 113 percent and the import-weighted average of tariff rates at 87 percent. With the removal of licensing, these tariff rates became effective restrictions on imports. Therefore, a major task of the reforms in the 1990s and beyond has been to lower tariffs. This has been done in a gradual fashion by compressing the top tariff rate while rationalizing the tariff structure through a reduction in the number of tariff bands. The top rate fell to 85 percent in 1993–1994 and 50 percent in 1995–1996. There were some reversals along the way in the form of new, special duties and the unification of a low and a high tariff rate to the latter, but the general direction has been toward liberalization, the top rate coming down to 20 percent in 2004–2005.

The 1990s reforms were accompanied by the lifting of exchange controls that had served as an extra layer of restrictions on imports. As a part of the 1991 reform, the government devalued the rupee by 22 percent against the U.S. dollar, from 21.2 rupees to 25.8 rupees per dollar. In February 1992 a dual exchange rate system was introduced, which allowed exporters to sell 60 percent of their foreign exchange in the free market and 40 percent to the government at the lower official price. Importers were authorized to purchase foreign exchange in the open market at the higher price, effectively ending exchange control. Within a year of establishing this market exchange rate, the official exchange rate was unified with it. Starting in February 1994, many current account transactions, including all current business transactions, education, medical expenses, and foreign travel, were also permitted at the market exchange rate. These steps culminated in India accepting the International Monetary Fund Article VIII obligations, which made the rupee officially convertible on the current account.

Liberalization of trade in services

Since 1991 India has also carried out a substantial liberalization of trade in services. Traditionally, services sectors have been subject to heavy government intervention. Public sector presence has been conspicuous in the key sectors of insurance, banking, and telecommunications. Nevertheless, considerable progress has been made toward opening the door wider to private-sector participation, including foreign investors.

Until recently, insurance was a state monopoly. On 7 December 1999, the Indian Parliament passed the Insurance Regulatory and Development Authority Act, which established an Insurance Regulatory and Development Authority and opened the door to private entry, including foreign investors. Up to 26 percent foreign investment, subject to obtaining a license from the Insurance Regulatory and Development Authority, is permitted.

Though the public sector dominates in banking, private banks are permitted to operate. Foreign direct investment (FDI) up to 74 percent in private banks is permitted under the automatic route. In addition, foreign banks are allowed to open a specified number of new branches every year. More than 25 foreign banks, with full banking licenses, and approximately 150 foreign bank branches are currently in operation. Under the 1997 WTO Financial Services Agreement, India committed to permitting 12 new foreign bank branches annually.

The telecommunications sector has experienced much greater opening to the private sector, including foreign investors. Until the early 1990s, the sector was a state monopoly. The 1994 National Telecommunications Policy provided for opening cellular as well as basic and value-added telephone services to the private sector, with foreign investors granted entry. Rapid changes in technology led to the adoption of the New Telecom Policy in 1999, which provides the current policy framework. Accordingly, in basic, cellular mobile, paging and value-added service, and global mobile personnel communications by satellite, FDI is limited to 49 percent subject to the granting of a license from the Department of Telecommunications. FDI up to 100 percent is allowed, with some conditions for Internet service providers not providing gateways (for both satellite and submarine cables) and infrastructure providers furnishing dark fiber, electronic mail, and voice mail. Additionally, subject to licensing and security requirements and the restriction that proposals with FDI beyond 49 percent must be approved by the government, up to 74 percent foreign investment is permitted for Internet service providers with gateways, radio paging, and end-to-end bandwidth.

FDI up to 100 percent is permitted in e-commerce. Automatic approval is available for foreign equity in software and almost all areas of electronics. One hundred percent foreign investment is permitted in information technology units set up exclusively for exports. These units can be set up under several programs, including Export Oriented Units, Export Processing Zones, Special Economic Zones, Software Technology Parks, and Electronics Hardware Technology Parks.

The infrastructure sector has also been opened to foreign investment. FDI up to 100 percent under automatic route is permitted in projects for the construction and maintenance of roads, highways, vehicular bridges, toll roads, vehicular tunnels, ports, and harbors. In construction and maintenance of ports and harbors, automatic approval for foreign equity up to 100 percent is available. In projects providing supporting services to water transport, such as operation and maintenance of piers, and loading and discharging of vehicles, no approval is required for foreign equity up to 51 percent. FDI up to 100 percent is permitted in airports, though FDI above 74 percent requires prior governmental approval. Foreign equity up to 40 percent, and investment by nonresident Indians up to 100 percent, is permitted in domestic air-transport services. Only railways remain off limits to private entry.

Since 1991 several attempts have been made to bring the private sector, including FDI, into the power sector but without perceptible success. The most recent attempt is the Electricity Bill 2003, which replaces three existing power legislations dated 1910, 1948, and 1998. The new bill offers a comprehensive framework for restructuring the power sector and builds on experience in the telecommunications sector. It attempts to introduce competition through private-sector entry side by side with public-sector entities in generation, transmission, and distribution.

The bill fully de-licenses generation and freely permits captive generation. Only hydropower projects would henceforth require clearance from the Central Electricity Authority. Distribution licensees would be free to undertake generation, and generating companies would be free to take up distribution businesses. Trading has been recognized as a distinct activity, with the Regulatory Commissions authorized to fix ceilings on trading margins, if necessary. FDI is permitted in all three activities.

Impact of liberalization

The ratio of total exports of goods and services to GDP in India doubled from 7.3 percent in 1990 to 14 percent in 2000. The rise was less dramatic on imports because increased external borrowing was still financing a large proportion of imports in 1990, which was no longer true in 2000. But the rise was still significant, from 9.9 percent in 1990 to 16.6 percent in 2000. Within ten years, the ratio of total goods and services trade to GDP rose from 17.2 percent to 30.6 percent. Nevertheless, this is substantially lower than the corresponding ratio of 49.3 percent achieved by China in 2000.

The Road Ahead

Despite substantial progress, tariffs remain high and must be compressed further. At this stage, the best course will be to first unify all tariff rates applicable to industrial goods at 15 percent, and then to bring them down to 10 percent by 2006–2007. Tariff uniformity has the advantage of minimizing incentives to lobby and therefore makes future liberalization easier. It is also likely to create less distortion than a more variegated tariff structure.

In the Doha negotiations, India should press for complete elimination of industrial tariffs by 2015 in all developed countries and by 2025 in all developing countries. Such a stance may enable India to achieve its long-sought objective of eliminating tariff peaks in developed countries that apply to labor-intensive products such as clothing and footwear. At the same time, the elimination of tariffs at home is fully consistent with India's liberalization program.

Agricultural tariffs in India have risen in recent years, and there is considerable room for lowering them, but political constraints are daunting despite the potential benefit, so that change is unlikely. This makes it essential for India to adopt a more flexible approach in Doha negotiations.

A particularly disturbing development on the trade policy front in India has been the rise of antidumping duties, which started in January 1993. By 1998, 45 anti-dumping cases had been initiated, covering 18 products. Definitive duties had been imposed in 11 cases, and a ruling of no injury reached in 2. India has now replaced the United States as the premier user of this instrument. Between July and December 2001, it carried out 51 anti-dumping investigations, which only reverses the economic liberalization policies introduced since 1991.

India has also embarked upon preferential trade arrangements that liberalize trade with one or more trading partners on a discriminatory basis. On balance, this is an inferior strategy toward trade liberalization, but perhaps for political and strategic reasons India's government has essentially committed itself to it. To minimize the damage to itself from possible trade diversion, it is more important for India to lower its external barriers as well. From a strategic point of view, India's recent decision to forge free trade areas with the members of the Association of Southeast Asian Nations makes eminently good sense. Focusing on creating a South Asian Free Trade Area, on the other hand, offers no such benefits and is almost certain to impose economic costs associated with the diversion of trade from more efficient outside sources.

Arvind Panagariya