India and liberalization: There was a 1966 before 199113 min read . Updated: 24 Jan 2016, 02:25 AM IST
The nation embarked on its first liberalization experiment with a characteristic combination of whim, status quo-ism and bad economics
The nation embarked on its first liberalization experiment with a characteristic combination of whim, status quo-ism and bad economics
Explaining the decision to not de-license the production of toiletries, the government spokesperson said that they were not “particularly a priority item, and it was thought that there was no purpose in allowing decontrol in a field in which we may not want substantial quantity to be added" (Planning for Industrialization, Jagdish Bhagwati and Padma Desai). Furniture components weren’t de-licensed either, for “they are minor items, and it was not thought important enough for being de-licensed".
The year was 1966 and independent India had just embarked on its first experiment with broad-based economic liberalization with a characteristic combination of whim, status quo-ism and bad economics. Reforms were a precondition for a much-needed increase in foreign aid. Unfortunately, neither did the increase in aid materialize, nor did the reforms survive.
A decade earlier, bruised by the efforts in securing a billion dollars in aid to finance the Second Five-Year Plan’s (1956-61) import bill, the government recognized the need for a more reliable source of funding for future plans. Braj Kumar Nehru, a senior Indian Civil Service officer and a cousin of Jawaharlal Nehru, was sent to Washington D.C. with a staff of three in the summer of 1958 to prepare the ground for concessional development aid for India from rich countries and the World Bank-International Monetary Fund institutions.
(The complete story behind this effort has been told in great detail by B.K. Nehru himself in his autobiography Nice Guys Finish Second. I.G. Patel, who was part of B.K. Nehru’s team, also devotes a chapter to these negotiations in his memoir Glimpses of Indian Economic Policy.)
Disdain for markets at home, implicit support for the Soviets abroad and, perhaps most of all, the incessant hectoring of the West by India’s de facto spokesperson to the world, Krishna Menon, had not won India too many friends in the rich world. A prolonged diplomatic and public relations effort ensued to make amends, at least in perception, if not in policy.
Wining—though alcohol was served with great reluctance, even then not to Indians, in case finance minister Morarji Desai was visiting D.C.—and dining, speechmaking, conferencing, appeals to conscience and publicization of our poverty were all part of the strategy.
Aided by sympathetic ears in Washington—most prominently Eugene Black (World Bank president), John F. Kennedy (first as senator and later as US president), senator John Sherman Cooper (a former ambassador to India), and Douglas Dillon (first as undersecretary of state and later as secretary of treasury), this effort culminated in the first meeting of the Aid India Club/Consortium (AIC) in April 1961.
India got a commitment for $1 billion a year for the next two years, and thereafter a further $3 billion to meet its foreign exchange deficit till the end of the Third Five-Year Plan. The US provided half of the money (in addition to half a billion dollars worth of wheat it was already supplying), with the rest of the world matching the other half.
Meanwhile, the economy was going through what American academic John P. Lewis called in his well-known 1962 book a “quiet crisis". Agricultural production had been virtually flat since 1960 (India: The Emerging Giant, Arvind Panagariya) and a respite in 1964-65 was immediately followed by two consecutive droughts. Defence spending doubled as a percentage of gross domestic product, or GDP, from 2% to 4% after the 1962 India-China war, putting further pressure on the public purse and foreign exchange reserves.
In addition, slow growth in exports and ambitious public spending under the Third Five-Year Plan created a balance of payments crisis. The problem was compounded by a declining ability to service debt—principal and interest payments were to reach 21% of export earnings by 1966-67.
Import controls, deployed harshly to keep the external deficit in check, further aggravated industrial production and therefore exports (India: Macroeconomics and Political Economy 1964-1991, Vijay Joshi and I.M.D. Little). Inflation followed soon enough, with headline and food inflation reaching 11% and 20%, respectively, in 1964-65 (India: The Emerging Giant, Panagariya). Food inflation was to get much worse over the next couple of years, before the Green Revolution—spurred by this very crisis—started showing results.
The foreign exchange situation was dire enough for the AIC to appoint a commission led by American economist Bernard Bell, under the World Bank’s aegis, in September 1964. Bell had earned a reputation of a successful reformer during his stint as a consultant to the Indonesian and Israeli governments. He submitted an interim report in May 1965 and the final version in August later that year—the same month India-Pakistan skirmishes had escalated into a full-blown war.
The diagnosis wasn’t surprising. Agriculture output was low, therefore cereal imports were high, which pushed out import of fertilizers and industrial inputs (for foreign exchange was strictly budgeted). The former slowed agriculture output, while the latter held back industrial production and export-related foreign exchange earnings. The cycle could only be broken by reallocating resources and attention away from heavy industries and towards agriculture.
In a happy coincidence, Lal Bahadur Shastri’s food and agriculture minister, C. Subramaniam, had already sown the seeds for the Green Revolution. Thus, this advice was fully taken on board. It is worth mentioning here the origin of post-Independence India’s neglect of farmers. Agriculture prices were artificially kept low to fund industrialization with the belief that it would not impact agriculture output.
Incentive channels were disregarded, for “Nehru himself did not consider the profit motive to be a key factor driving farmer’s behaviour, and even when he accepted its importance, he leaned against it on normative grounds, arguing that he did not want to encourage acquisitiveness beyond a certain measure." (Democracy, development, and the countryside: Urban-rural struggles in India, Ashutosh Varshney).
The attitude was not just condescending but also laughable in hindsight, given the political importance minimum support prices were to take from the 1970s.
Next on the table were structural reforms: substantial decontrol of imports and rationalization of export subsidies (devaluation was supposed to neutralize their adverse impact on domestic producers); a reduction in the industrial licensing regime; increased private foreign investment; the decontrol of fertilizer production and distribution; the promotion of the private sector; and the scaling back of the public sector enterprises (Cycles in Indian Economic Liberalization, 1966-1996, David Denoon).
There was an increasing disenchantment with the existing licensing regime within Indian policy circles even before the Bell Commission. In September 1963, the industrial development procedures committee under T. Swaminathan had been set up. Reporting in 1965, it suggested a complete de-licensing of industries that did not require any imported inputs, machinery or raw material (Planning for Industrialisation, Bhagwati and Desai)—lack of export earnings had kept policymaking hostage to foreign exchange budgeting since Independence.
While this criterion was naive in ignoring the second-order effects on imports, the basic thrust nevertheless was in the same direction as that of Bell’s. Accepting the committee’s recommendation in May 1966, the government also added a caveat for the protection for small and cottage industries. Finally though, the list of industries de-licensed was fairly arbitrary, with products such as toiletries, furniture components and milk products kept out of the list for pretty flimsy reasons.
Alongside industrial de-licensing, the import regime too witnessed perceptive liberalization. Industries covering four-fifths of the organized sector’s output now had the freedom to import raw materials and components, subject to sourcing and securing of licences. However, the impact was limited, for the chaotic principle of subjecting licences to “indigenous non-availability" still plagued the system.
How entrenched import controls had become in the Indian psyche can be seen from that fact that for at least three decades, most Bollywood villains were smugglers—people who import without a licence. Small steps towards the rationalization of export subsidies were taken as well.
Bell’s most controversial and fateful recommendation was the devaluation of the rupee. There had been sustained pressure from donors even before Bell had landed in India. At the same time, the need to devalue had long been recognized by Indian economists and politicians such as C. Subramaniam and Ashok Mehta, then deputy chairman of the Planning Commission (Nice Guys Finish Second, B.K. Nehru).
Not only was the exchange rate believed to be grossly overvalued—thus uncompetitive—but in the presence of multiple exchange rates, the system had become so confusing that no one really knew the average operating rate of the rupee (Glimpses of Indian Economic Policy, I.G. Patel).
However, it was such a politically controversial issue—due to the frankly ridiculous equation of one’s exchange rate with one’s prestige in the world—that finance minister T.T. Krishnamachari and Reserve Bank of India governor P.C. Bhattacharya were ready to resort to elaborate gimmicks that could in theory deliver an “effective devaluation", but were not ready for the real thing (Glimpses of Indian Economic Policy, Patel, and Nice Guys Finish Second, Nehru).
Matters were not helped by Bell’s style of functioning. Impatient to seal his reputation by reforming India, he came with the arrogance of an economist who had “fixed countries", and a personality of a “dried up American"—in the words of B.K. Nehru. None of this endeared him to his Indian interlocutors. Indians wanted more time and discretion to prepare consensus at home. Thus, despite having a lot of common ground, negotiations turned into slanging matches (Glimpses of Indian Economic Policy, Patel).
Nevertheless, however much the Indian side tried to resist pressure, it had been made clear via various channels that accepting these recommendations was a necessary condition for the availability of aid to India. The change in leadership at the World Bank—which Bell effectively represented—wasn’t too helpful here.
The new president, George Woods, was not as sympathetic to India as his predecessor Eugene Black (the very same man who had helped form AIC) despite, or rather, because Woods used to be government of India’s banker in New York (Glimpses of Indian Economic Policy, Patel).
A former employee had now become the boss and he was keen to stamp his authority. In the meantime, US aid to both India and Pakistan had been suspended as a result of the war. The need for foreign funds was therefore acute.
In absence of any other viable option, devaluation became an inevitable towards the end of 1965. Meanwhile, Shastri had gotten rid of his obstinate finance minister Krishnamachari and replaced him with an economically illiterate, but clever, virtually unknown Calcutta lawyer Sachin Chaudhary, who would do as told.
Shortly thereafter, chief economic adviser I.G. Patel and RBI governor Bhattacharya went off to Washington to inform the IMF of India’s intention to devalue. But within weeks, Shastri died in Tashkent and all bets were off.
Indira Gandhi became prime minister on 24 January 1966. It took a trip to Washington that April, and extensive consultation with Indian economists and policymakers, to make her mind up in favour of the devaluation. Soon enough, a team of finance ministry officials led by Ashok Mehta went to D.C. to discuss the new exchange rate and other issues with the IMF.
It was decided to “take a big bite" (Glimpses of Indian Economic Policy, Patel) since such decisions were not taken every day. To appreciate the cavalier fashion of policymaking, it is useful to quote the following excerpt from B.K. Nehru’s—by then the ambassador to the US—memoirs: “[F]ixation of an exchange rate is a matter of complete guesswork... Pierre Paul (then head of the IMF) had wanted Rs10 but I thought Rs7.50 would be about right. He (Govindan Nair, economic secretary) said that gave a rate of Rs21 to the pound, which meant that the value of a rupee would be less than a shilling. That he said was psychologically bad. (But) I said... Rs7.50 was a nice round figure".
On 6 June 1966, the value of the rupee went from Rs4.76 to Rs7.50 to a dollar, a devaluation of 36.5%. The Congress leadership (which had not been consulted), commerce minister Manubhai Shah (who lost power to set multiple rates), the intelligentsia (anti-Western by instinct), and everyone else who saw it as a loss of face, kicked up a ruckus.
The timing also turned out to be inopportune. India was hit by another drought that very summer. Food shortages, price rise and an industrial recession followed (Planning for Industrialisation, Bhagwati and Desai). Since most public discourse across the world is done on a post hoc ergo propter hoc basis, the devaluation was blamed for any and every problem—and there were many—in the economy.
To compound the economic hardship, the AIC meeting that followed “was a big disappointment and indeed a betrayal" (Glimpses of Indian Economic Policy, Patel). Much of the promised non-project assistance did not materialize. This aid was necessary not only to tide over the crisis, but to deal with the short-term external balance deterioration that typically follows devaluations.
(Devalued or cheaper exchange rates make a country’s exports more competitive and imports more expensive. However, since it takes time for the quantity of trade to respond to those prices—you need to set up production to substitute for the now expensive imports and/or find buyers for now cheap exports—the immediate reaction of the trade balance is to deteriorate.)
The purported reasons were the supposed superficiality and inadequacy of the liberalization package, though the political considerations of the Cold War were believed to be the real reason (Accidental India, Shankkar Aiyar). Vocal Indian opposition to the Vietnam War had strained relations and US president Lyndon B. Johnson kept food aid on a tight leash—the so called “ship-to-mouth" policy.
The whole episode turned out to be a political disaster for Indira Gandhi, who lost face, political capital and faith in donors. The financially conservative and cautiously liberal economic policies were to be aborted soon. This was particularly unfortunate since the long-term resource allocation benefits of the liberalization programme and devaluation were not appreciated at that time.
It was in this atmosphere of disenchantment that the 1967 general election was fought. A weakened Indira Gandhi was returned to office; she began work on forging a new political identity—that of a radical populist—to upstage the “right-wing" party leadership that had sought to dominate her (India: Macroeconomics and Political Economy 1964-1991, Joshi and Little).
A decade of economic vandalism followed.
She nationalized the banks, insurers, coal and oil. She brought in draconian controls on private and foreign activity. She nationalized the wheat trade, at social and eventually political cost. Only towards the end of the 1970s, economic realities forced a rethink, a shift that would culminate in the liberalization unleashed in 1991.
Before I end, a couple of observations. First, a “what-if?" And second, a comment on how India reforms.
Shastri—a pragmatic man with no particular affinity for socialism or planning who, in fact, had a dislike for controls—was receptive to reforms (Indira Gandhi, the ‘Emergency’ and Indian Democracy, P.N. Dhar). He had already shown his commitment to liberalization by replacing his unyielding finance minister. Devaluation under his aegis, in the winter of 1965-66, could have been better managed (Glimpses of Indian Economic Policy, Patel), better timed—before drought caused a price rise—and less politically divisive given his invulnerable position after the war.
What changed with Indira Gandhi was not so much the ideology—she was considered pragmatic (Indira Gandhi, the ‘Emergency’ and Indian Democracy, Dhar)—but a new willingness to jeopardize the economy for political expediency.
“A wise man goes when he can. A fool goes when he must." While comedian Bill Connolly was referring to nature’s call, it is equally applicable to reforms. Even though it is “easier" to push reforms under the cloak of a crisis, their success is also less evident precisely because the economy is going through a crisis.
This lag in results is perhaps why all attempts at liberalization of the Indian economy have been so short-lived—even the celebrated duo of P.V. Narasimha Rao and Manmohan Singh lost their “reformist zeal" in less than two years.
Thus, reforming when the economy is doing well is always preferable, since the government has the resources to alleviate the short-term pain they inevitably cause. Unfortunately in India, even when the case for reforms is clear, governments dither and wait for an external impetus. This saves them the bother of expending political capital in making an intellectual case for reforms.
Perhaps, in the next Mann Ki Baat, Prime Minister Narendra Modi will use the opportunity to make the case for a reform that is dearest to him, but is difficult to sell.
Ankit Mital is an economist and a lapsed academic. He is currently writing a book on the 1991 economic crisis and liberalization. His twitter handle is @Molto_Vivace_88
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