REFORMS IN THE FINANCIAL SECTOR AND CAPITAL MARKETS 9. REAL SECTOR PERSPECTIVES AND Although this report is mandated to review the financial sector and capital markets and recommend measures to reform and strengthen them, it would be useful to look at the real sector to the extent to which it impacts the financial sector. It is with this in mind that perspectives on the real sector are presented and some suggestions made.
9.2.1 Sluggish Local Demand The prices of various asset classes such as bullion, real estate and stocks (especially the midcap stocks, which represent the equity investments of the small investor) have fallen in the recent past resulting in significant loss of wealth the deferment of expenditure by households. The urban markets for consumer products, especially durables and two wheelers are growing, while penetration in the rural markets has remained low due to the slow growth in rural income levels. (Annex. 9.1) 9.2.2 Poor Development of Infrastructure There have been inordinate delays in the inflow of investments into the infrastructure sector and the implementation of projects. Further, there has been a decline in government spending over the last few years as illustrated by the decrease in gross fixed capital formation by the public sector as a percentage of GDP from 9% in 1994-95 to 7.4% in 1996-97. (Annex. 9.2)
9.2.3 Slack Industrial Investments Many industries in the economy are characterised by overcapacity following the large capacity additions in the first half of the current decade. Further, the lack of availability of funds for new projects limits fresh industrial investments.
9.2.4 Inadequate export competitiveness Indian exports in dollar terms had grown consistently at about 20% between 1993-94 and 1995-96. However, they have declined sharply in the last two years to 4.0% and 2.7% respectively. Most Indian export products are commodities with limited brand equity in international markets. Indian goods are also perceived as being of low quality. This makes our export basket very vulnerable to competition. The transport and port infrastructure in the country is inadequate and inefficient to meet the delivery schedules of international customers. The capital costs incurred by Indian exporters are often higher than that of their foreign peers, which erodes their competitiveness. The economic developments in East Asia and the consequent slowdown in demand in the region, coupled with the sharp depreciation of those currencies, has adversely affected Indian exports in the past year.
9.2.5 Domestic overcapacity and import threat Large capacity additions have been made in sectors such as steel and cement, based on high demand growth estimates. However, the slowdown in local demand, has resulted in severe overcapacity and intense competition among producers. This in turn has contributed to a decline in prices and low profitability in these industries. The significant depreciation of East Asian currencies following the currency crisis in 1997 and the decline in local demand in that region has increased the threat of imports from these markets in commodity sectors such as steel, chemicals, paper and fibres. This has also resulted in a sharp fall in global prices for commodities thereby having an adverse impact on the domestic industry (Annex. 9.3). 9.2.6 Uneconomic scale of operations and high cost structure Many companies in sectors such as PFY and paper suffer from the problem of uneconomic scale of operations, which renders them uncompetitive on costs, and results in large losses and sickness. The Board for Industrial and Financial Reconstruction (BIFR) is unable to effect timely wind-up of sick units, and defaulting units referred to the BIFR are freed of their debt service liabilities. In order to maintain operations, these units continue to sell products at variable costs and exert pressure on the viability of competitive companies. Lack of adequate infrastructure and high power costs further erodes competitiveness of viable companies.
9.2.7 Technology The major problems faced by the industry relating to technology are the outdated technology used in industries like textiles and low research and development (R&D) spending in industries like pharmaceuticals. 9.2.8 Labour Between now and the year 2025, India will be adding 446 million people to its population and 352 million people to its work force. India, therefore, has to create 352 new million jobs, apart from protecting and enhancing the career opportunities of the existing 425 million people. (Annex. 9.4) In the context of the age of information and automation and widespread awareness about modern day comforts of life in youth, creation of employment opportunities on such a large scale is a major challenge for the country. Creation of jobs cannot come about unless large-scale opportunities are created in various sectors, more particularly in sectors with high employment elasticity. Employment elasticity by itself has no meaning unless deployment of labour is flexible for otherwise entrepreneurs can resort to labour saving devices by incurring a capital penalty.India’s current labour laws have resulted in making labour as a factor of production in the organised sector non-competitive, inflexible and expensive. The flip side is in terms of gross misuse of 270 million labour by the unorganised sector through sharp labour practices. Even within the organised sector, a rigid labour policy has led to not only poor productivity but also hurdles to productivity such as in the banking, insurance and transportation sectors. Despite having a large labour force, entrepreneurs in India in the organised sector, given a choice, prefer to go in for labour saving techniques and automation as the problems of managing labour and hostile trade unions are considered to be immense. Quixotically, this has resulted in Indian labour laws and policies oriented to protecting 28 million jobs in the organised and government sectors at the cost of creation of 350 million new jobs. 9.2.9 Infrastructure funding The local industry has been constrained by the decline in investor interest in the equity markets. This is reflected in the steep fall in the amount of equity funds raised from the markets through public and rights issues over the last three years. While Rs. 40.6 bn. of equity was raised through public and rights issues in 1994-95, the amount had declined to Rs. 9.2 bn. in 1997-98. The share prices as well as industry indices of capital intensive industries have underperformed the market while the prices and indices of have outperformed the market. This indicates that the market is not inclined towards providing funds to the sectors which need them most. The gearing of projects currently being implemented has been increasing, even as volatility and risks in the Indian industrial sector have risen following increased globalisation and competition. This has led to a significant increase in financial risk of projects, and sharp deterioration in their viability. The average cost of debt borrowed by local manufacturers is higher than that of their foreign counterparts. This compounds the adverse impact of the large debt burden on projects and strains the short-term cashflows of projects. The capital intensive nature of infrastructure projects and long gestation period of these projects results in long payback periods and higher risks for these projects. These projects therefore require long term funds for their funding. In the absence of domestic sources of funds of the requisite maturity and risk taking ability, these projects would have to rely extensively on foreign equity and debt to achieve financial closure. However, revenues from infrastructure projects in the power and telecom sector are rupee denominated. Thus extensive reliance on foreign funding sources would subject these projects to exchange risks. A sharp depreciation in the rupee would result in higher losses for the operators in the event that the higher costs cannot be passed on to the end user or alternatively it will result in a sharp escalation in end user charges. It is therefore essential to develop long term domestic funding sources to fund infrastructure projects. Infrastructure sectors, such as roads and urban infrastructure are also characterised by the low payment ability of the end-users. 9.2.10 Agriculture product pricing Indian agricultural sector suffers from low productivity levels compared to the international standards, particularly in the case of foodcrops. The gap between the yield levels in India and the other economies indicate the extent of challenge and opportunities facing India’s agricultural sector. The poor yields are a result of the large dependence of the India’s population on the sector. Overcrowding and the consequent pressure of population on land have led to sub-division and fragmentation of holdings, decline in the area of land per capital, disguised unemployment in agriculture and therefore, low marginal productivity of labour in the sector. The low yield levels are also due to the presence of inadequate non-farm services, such as provision of finance, marketing etc. Technological factors responsible for the low yields relate to usage of old and inefficient methods and techniques of production. Most of the farmers throughout the country have also to depend mainly on monsoons and reliance on irrigation facilities remains low. The real problem in the sector is identified to be the unremunerative pricing structure that exists within the sector. Experience of USA and other countries suggest that high incentive prices were the key to any scheme for intensive agricultural development. However, till recently, Indian policies did not permit movement of foodgrains from the surplus states to the deficit states resulting in a price distortion in the system. The government has now permitted free movement of foodgrains within the country. Prices in the domestic market are much lower than the international prices, mainly for the foodgrains .The grain sector remains largely closed from the global markets. International prices for rice in 1996 was US$ 338/tonne while the domestic price for the same year is at US $ 200.5. For wheat, the corresponding figures are US $190 internationally and $ 157.5 domestically. However, for commodities such as sugar, soyabean meal, coffee etc, the prices are more aligned to the international prices. This also accounts for the poor incentive for enhanced production of agricultural commodities. 9.2.11 Gross capital formation in agriculture The potential of the agricultural sector lies in the fact that the capital-output ratio for the sector is low at 2.5 to 3 and is substantially low compared to the overall capital-output ratio for the economy as a whole at around 4. This implies that a small input of capital will bring in a large output of agricultural goods. To achieve a rapid increase in incomes a greater proportion of investment should be made in agriculture. However, trends show that there has been a sharp reduction in the agricultural gross capital formation as a proportion of total gross capital formation (GCF) in the economy. While in 1980-81, the share was around 15%; it has declined to only around 2% recently. Further, there is a decline in the share of public investments in total investment in the sector. The share of public investments to total investments stands at around 16% in 1996-97, showing a decline from 38.7% in 1980-81. This indicates the relative neglect of the agricultural sector by the government.
9.3 SUGGESTIONS Suggestions to vitalise the real sector are as follows: 9.3.1 Reduction in excise duty, growth in agricultural income through farm reforms and higher spending on infrastructure would generate demand for consumer goods. Reducing indirect taxes, such as excise duties and sales taxes can raise the demand for consumer goods. In the past, these measures have provided a fillip to demand for consumer durables like air-conditioners, colour television sets and refrigerators. The rise in demand for consumer goods will also drive the demand for intermediates like steel, aluminum and plastics. Further, the rationalisation of the sales tax and octroi structure in the country, would result in greater manufacturing and distribution efficiencies and create a common domestic market in the country. The growth in the intermediates such as steel and cement as well as capital goods industries needs to be stimulated through higher spending on infrastructure, measures to encourage investments in housing and a policy framework which results in greater foreign participation in industrial and infrastructure projects. Investments in the infrastructure sector have a multiplier effect on the investments in the industrial sector. The purchasing power of customers in the rural markets needs to be increased significantly through agricultural sector reforms. An improvement in the rural income levels is critical to sustain the growth in demand for consumer goods in the country. 9.3.2 Entry of organised sector in areas reserved for small scale units and investments in infrastructure would enable Indian industry to become export competitive Sectors, which are currently the sole preserve of SSI units, need to be dereserved in phases. This will permit the entry of the organised sector into these industries and improve the competitiveness of the Indian exporters. Players in the organised sector will have greater financial resources to invest in marketing, state-of-art technology and extend better credit terms to customers. The minimum requirement of 75% export sales by export oriented units (EOUs) should be relaxed so that the aggregate export volumes from the country are increased and producers can avail the benefits of duty free import of capital goods. The increase in investments into the infrastructure sector would reduce port congestion and road bottlenecks besides improving power availability and communication links. This would enable domestic industry to control costs and meet delivery schedules and thereby strengthen its export competitiveness. The RBI reduced the export credit rates in the beginning of 1998-99 and this has already resulted in greater credit offtake by exporters. The export credit extended to sectors with export potential should be treated as part of the priority sector lending obligations of commercial banks. The depreciation of the Indian rupee will enable Indian exports to sustain the current level of exports in the wake of threat from their competitors in Asia. 9.3.3 Alignment of import tariffs to WTO committed levels, institutionalisation of effective anti-dumping investigation cells, encouragement of investments in infrastructure, contemporary technology and consolidation would enable Indian industry to become more competitive and meet threat from imports. The government has significantly reduced the import tariffs in many sectors as part of its economic reform programme. Import tariffs should be aligned with bound rates and reduced gradually to meet levels as committed to the WTO by the year 2000-01. This will also make capital formation attractive to the foreign investor and augment badly needed government revenues. At the same time, effective anti-dumping investigation cells to address unfair competition and injury to domestic manufacturers, must be institutionalised. The global demand supply balance in industries such as steel and petrochemicals has been adversely affected following the economic developments in East Asia during 1997. This has resulted in a sharp fall in prices, thereby threatening the viability of local producers. The government set up an antidumping cell in 1997 but the investigation process needs to be streamlined to reduce the time taken to introduce antidumping/safeguard duties. The excise exemptions extended to SSIs have increased the number of players in many industries. This has also fragmented capacities and affected the profitability of the organised sector. This indirect tax structure needs to be rationalised in order to encourage consolidation in the industry and improve its competitiveness. 9.3.4 Mergers and acquisitions and policies which enable winding up of sick units would strengthen Indian industry. Units should be segregated into four categories - viable units, which are currently meeting capital serving obligations, viable units, with deteriorating performance and concern about ability to service capital, viable units, which are currently not meeting capital serving obligations and unviable units. Measures should be taken to strengthen viable units, particularly those in current financial distress but whose problems can be resolved through restructuring efforts. At the same time, effective bankruptcy legislation and restructuring of the BIFR should ensure that unviable units are closed down. Facilitating mergers and acquisitions should encourage the restructuring of Indian industry. The government should identify a set of viable and globally competitive Indian industries and ensure that funds from the household and financial sectors are channeled towards these industries. 9.3.5 Encouragement of creation and use of technology upgradation funds for different industries would improve the productivity and efficiency of local manufacturers. The government should provide tax benefits on investments in research & development that will contribute to the competitiveness of domestic producers. India needs a flexible labour policy that can enable government and entrepreneurs mark labour productivity and costs to market, redeploy or retrench unproductive labour, and have freedom of choice of new labour.9.3.6 Flexible labour policies can catalyse investment and creation of millions of new jobs. India needs a flexible labour policy that can enable government and entrepreneurs mark labour productivity and costs to market, redeploy or retrench unproductive labour, and have freedom of choice of new labour. Only such a policy can impart flexibility to labour as a factor of production, thereby encouraging new investments, especially those that are employment elastic. In the process, the country stands to benefit by being able to provide employment opportunities to the 350 million who are expected to join its working force. 9.3.7 Liberalisation of the agricultural sector with respect to pricing of farm produce, product movements, imports and exports would energise growth and employment in the economy. Recognising that the basis problem for the sector is the unremunerative pricing for the farmers, the need would be to allow the farmers to realise better prices for their products. This can be done through liberalising both the domestic and the international restrictions on trade in the agricultural produce, especially the cereals, which would enable the farmers to realise benchmarked international prices, leading to better practices and thereby improved productivity. Futures markets for crops should be developed to provide a way of hedging risks. Government should take an active role in the sector. Better pricing for the produce should be able to incentivise private investment to flow into the agricultural sector. Agro industries may be dereserved from the small-scale sector to enable more private investments to flow into the sector. Agriculture is still largely dependent on monsoons. The reliance on irrigation facilities needs to be enhanced with government funding in this area. There is a need to educate farmers to optimise the usage of irrigation. Canal water charges may be raised to cover operation and maintenance, and improve water delivery system by turning canal irrigation over to users. Farmers should be provided with incentives to shift over to mechanised farming techniques. However, a rapid increase in mechanisation is not desirable for India. Large-scale mechanisation would have its negative impact on increase in unemployment with agricultural workers becoming surplus and with no alternative source of employment generated in the short-term. A suitable marketing structure needs to be developed with enhanced role for agricultural cooperatives. This would reduce the number of intermediaries and also could both improve the profits for the farmers and reduce prices for the consumer. Credit needs to be made available to the farmers to enable them with the capacity to hold on to their crops till the market conditions are favourable. 9.4 SUMMARY To sum up, reforms in the real sector are equally important and complementary to reforms in the financial sector and capital markets. The focus of reforms in the real sector has to be on agriculture, labour policies and infrastructure. Apart from this, structural deficiencies in Indian industry in terms of technology, scale and competitiveness have to be urgently tackled.
ANNEXURES Penetration in Indian markets (per '000 households)
Source: NCAER demographic survey
Source: NCAER demographic survey Decline in government expenditure constrains infrastructure
Source: Indian Economic Survey 1997-98
Fall in Commodity Prices
Source: Published sources India – population profile
Source: Census Bureau
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