Report No. 9899

OED Study of Bank Support of Industrializationin Newly Industrializing Countries(In Four Volumes) Volume III: Case Study of India

September 12, 1991

Operations Evaluation Department

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ACROKYMS

BAPINDO - Bank Pembangunan Indonesia (Development Bank of Indonesia)BREL - Bharat Heavy Electricals Limited (India)BLK - Vocational Training Center (Indonesia)BOx Bank of KoreaBPPT - Sadan Psngkajian Dan Penerapan Teknologi (Agency for the

assessment and application of technology)CEM - Country Economic MemorandumChaebol - Large conglomerate business houses in KoreaCN - Citizen National Bank (Korea)CSIR - Council for Scientific and Industrial Research (India)DFC - Development Finance CorporationDFI - Development Finance InstitutionDRC - Domestic Resource CostEOU - Export Oriented UnitEPZ - Export Processing ZoneERP - Effective Rate of ProtectionERR - Economic Rate of ReturnFERA - Foreign Exchange Regulation ActFRR - Financial Rate of ReturnFTZ - Free Trade ZoneGDP - Gross Domestic ProductGEC - Genetic Engineering Center (Korea)GIC - General Insurance Corporation (India)GIP - General Improvement Plan (BAPINDO)GNP - Gross National ProductHCI - Heavy & Chemical IndustriesHMT - Hindustan Machine Tool. (India)ICC - Indian Coal CompanyICICI - Industrial Credit and Investment Corporation of IndiaICOR - Incremental Capital Output RatioIDBI - Industrial Development Bank of IndiaIDRA - Industrial Development and Regulations Act (India)IER - International Education ReportIFC - International Finance CorporationTFCI - Industrial Finance Corporation of IndiaIISCO - Indian Iron and Steel CompanyIIT - Indian Institute of TechnologyIMF - International Monetary FundIRBI - Industrial Reconstruction Bank of IndiaIS - Import SubstitutionKAIST - Korea Advanced Institute of Science & TechnologyKDB - Korea Development BankKDFC - Korea Development Finance CorporationKEPCO - Korea Electric Power CompanyKHIC - Korea Heavy Industries CorporationKIER - Korea Institute of Energy & ResourcesKIET - Korea Institute of Economics & TechnologyXSRI - Korea Standard Research InstituteKTAC - Korea Technology Advancement CorporationKTDC - Korea Technology Development CorporationLIC - Life Insurance Corporation (India)

This document has a restricted distribution and may be used by recipients only in the perform n--

LNG - Liquitied Natural GasNECON - Metallurgical Engineering Consultancy company (India)MOST - Ministry of Science & Technology (Korea)MRTP - Monopoly and Restrictive Trade PracticesMVA - Manufacturing Value AddedNBFI - Non-Bank Financial InstitutionNIC - Newly Industrializing CountryNIF - National Investment Fund (Korea)NSIC - National Small Industries Corporation (India)NTB - Non-Tariff BarrierOECD - Organization for Economic Cooperation & DevelopmentOED - Operations Evaluation DepartmentOGL - Open General LicenseOTA - Office of Technology Assessment (USA)PCR - Project Completion ReportPDFCI - Private Develo.ment Finance Company of IndonesiaPE - Public EnterprisePMP - Phased Manufacturing ProgramPOL - Petroleum oil and LubricantsPPAR - Project Performaice Audit ReportPUSRI - P.T. Pupuk Sriwidjaja (State owned fertilizer company)

(Indonesia)QR - Quantitative RestrictionRBI - Reserve Bank of IndiaR&D - Research & DevelopmentREP - Replenishment licenses (India)SAIL - Steel Authority of India LimitedSAL - Structural Adjustment LoanSAR - Staff Appraisal ReportSFC - State Financial Corporation (India)SIDC - State Industrial Development Corporation (India)SMI - Small & Medium Scale IndustrySMIB - Small & Medium Industries Bank (Korea)SMIPC - Small & Medium Industries Promotion Corporation (Korea)SSI - Small Scale IndustryTCO - Technical Consultancy Organization (India)TEDC - Technician Education Development Center (Indonesia)TELCO - Tata Engineering and Locomotive Company (India)TFP - Total Factor ProductivityTISCO - Tata Iron and Steel Company (India)UNDP - United Nations Development ProgramUNESCO - United Nations Educational. Scientific and Cultural

organizationUPPINDO - Usaha Pembiayaan Pembangunan IndonesiaUTI - Unit Trust of IndiaVCR - Video Cassette RecorderWDR - World Development Report

OED STUDY OF BANK SUPPORT OF INDUSTRIALIZATIONIN NEWLY INDUSTRIALIZING COUNTRIES

VOLUME III

CASE STUDY OF INDIA

TABLE OF CONTENTS

Page No.

I. INTRODUCTION ............................................ 1

II. THE DEVELOPMENT OF INDIAN INDUSTRY ...................... 3

A. Background and Macroeconomic Setting 3............... 3B. Growth and Diversification of Indian Manufacturing

Industry .......................................... 10C. Market Structure and the Impact of Regulations ...... 13

(a) Industrial Licensing ........................... 19(b) MRTP Regulations ....... 0.....0................. 20(c) Small-Scale Industry ........................... 21(d) Exit Policies .................................. 22(e) Price Controls ................................. 22

D. The Trade Regime ........................... ........ . 23

E. The Financial Sector and Industrial Finance ......... 30F. Technology Policy ........................ . ......... 34G. Education and Training ............................. 39H. Impact on Industrial Efficiency ..................... 41I. Assessing the Role of Interventions ................. 47

III. THE BANK'S ANALYSIS OF INDIAN INDUSTRIALIZATION ......... 50

A. Introduction ............... *................0......... 50B. Assessing Structural Change ......................... 50C. The Slowdown in Industrial Growth During the 1970s .. 53D. Understanding Indian Industrial Performance ......... 55E. Evaluating Government Intervention .................. 60

IV. BANK'S LENDING OPERATIONS IN INDIA ...................... 64

A. Steel Industry ...................................... 64B. Development Finance Institutions .................... 65C. Industrial Import Credits ........................... 67D. Fertilizer Industry ................................. 69E. Small Scale Industries .............................. 70F. The 1980s ........................................... 72

V. CONCLUSIONS ............................................. 75

OED STUDY OF BANK SUPPORT OF INDUSTRIALIZATIONIN NEWLY INDUSTRIALIZING COUNTRIES

VOLUME III

CASE STUDY OF INDIA

I. INTRODUCTION

1.01 Indian industry has been extensively studied by the World Bank inthe past two decades. The broad development of the sector and policies per-taining to this have been analyzed regularly in CEMs and various industrysector/policy studies. In addition, several industrial subsectors have beenexamined in considerable depth, in the early 1970s as part of the industrialimports credit, later in the context of export promotion, small-scale indus-try research, and specific Bank projects, or simply as analytical studies tohelp the government in industrial policy formulation and reform. The result-ing volume of analysis is far greater than for the other two countries cov-ered in this OED study (Korea and Indonesia), and perhaps also than for anyother client of the Bank.

1.02 In part this reflects India's position as the largest borrower ofBank resources and the size and diversity of its industrial sector. In partit is the result of the relatively poor performance of Indian industry, whichprompted the Bank to analyze its problems intensively. Its traditionallydelicate relationship with India called for greater persu sive effort, sup-ported by more careful research, than for most other bor-iwers. The gradualmove to policy reform in the 1980s led the Bank to mount a series of studiesof the general industrial policy regime as well as important subsectors.

1.03 This case study has to be more selective in reviewing Bank work onIndian industry than was necessary for Korea or Indonesia. A broad sample ofstudies, starting from the Bell report of 1965, has been chosen to reflectthe Bank's approach in policy and detailed industry analysis. Most attentionis, nevertheless, given to studies prepared after 1985, both because thisperiod marks the acceleration of policy reform and because it contains themost comprehensive analyses of Indian industrialization. The followingreports were drawn upon for this review.

Manufacturing Industry with Special Reference to Public Sector Enterprise,Vol. VI of the "Report on India's Economic Development Effort" (TheBell Report), 1965.

Certain Aspects of the Indian Stee' try, No. AS-111a, 1966.

India: Review of Trends in Manufa _ng Industry, No. SA-9a, 1970.

India: Economic Situation and Prospects of India, CEM, No. SA-25a, 1971.

India's Export Prospects, No. SA-26a, 1971.

Survey of Commercial Vehicle Industry: India, Background Paper for Appraisalof 8th Industrial Imports Credit, No. 165-IN, 1973.

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India: Export Performance, Problems, Policies and Prospects, No. 1352-IN,1977.

India: Economic Situation and Prospects of India, CEM, No. 1529-IN, 1977.

India: Economic Situation and Prospects of India, CEM, No. 2431-IN, 1979.

India: Cement Subsector Study, No. 3141-IN, 1980.

India: Non-Electrical Industrial Machinery Manufacturing - A SubsectorStudy,

No. 5095-IN, 1984.

Indian Industry: A Review of Selected Subsector Studies, Inderjit Singh(Draft), South Asia, IDF Division, 1985.

Sectoral Problems, Programs and Policies, Technical Appendix to 1986 CEM,No. 6090-IN, 1986-a.

India: Industrial Regulatory Policy Study, No. 6479-IN, 1986-b.

India: An Industrializing Economy in Transition, CEM, No. 6633-IN, 1987-a.

India: Policies for Industrial Technology Development, No. 6715-IN, 1987-b.

India: Development of the Electronics Industry, A Sector Report,No. 6781-IN, 1987-c.

India: Export Developments A Proposed Strategy, No. 6663-IN, 1987-d.

India: Recent Developments and Medium-Term Issues, CEM, No. 7185-In, 1988.

India: Staff Appraisal Report, Export Development Project, No. 7603-IN,1989-a.

India: Poverty, Employment and Social Services, CEM, No. 7617-IN, 1989-b.

India: Staff Appraisal Report, Electronics Industry Development Project,No. 7704-IN, 1989-c.

India: Capital Goods Sector Update: Development Strategy in a ChangingEnvironment, No. 7895-IN, 1989-d.

India: Industrial Technology Development Project, No. 7864-IN, 1989-e.

India: Trends, Issues and Options, CEM, No. 8360-IN, 1990.

India: Policies for AdJustment with Growth, CEM No. 9142-IN, 1991.

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II. THE DEVELOPMENT OF INDIAN INDUSTRY

A. Background and MHacroeconomic Setting

2.01 When India gained independence in 1947, it already had a fairlysizeable and diversified base in modern manufacturing industry. Textileproduction had started nearly a century earlier, and various basic industrialproducts, like cement, paper, steel, some chemicals, as well as a broad rangeof consumer and engineering goods, had been established for decades. It hadinherited a good physical infrastructure and a well-functioning structure ofadministration from the British. It had a dynamic entrepreneurial class anda small but adequate group of trained engineers and technicians. The legalsystem was conducive to modern enterprise. Despite its very low incomelevels and the preponderance of a backward agricultural sector, therefore,the government held high hopes of rapid economic growth led by the industrialsector.

2.02 The size of the economy (the world's seventh largest in area andsecond largest in population) was taken to be an advantage in the industrial-ization effort However, it also influenced strongly the economic strategyadopted by the Government. Some of the basic parameters of the strategy hadbeen laid down long before independence. The Congress party, with itsGandhian and socialistic ethos, had decreed (in policy statements in 1938,1945 and 1948, see the Bank's 1970 report) its priorities as serving thedomestic market, setting up heavy industry, state ownership of 'basic' sec-tors, support of small-scale industry and the equitable distribution ofwealth. Self reliance (in a variety of senses) was an explicit goal, withlarge-scale public ownership and the build-up of heavy industry the mainmeans: all this was conditioned by the beliefs that the 'continental' sizeof the economy made a near-autarkic strategy feasible, that comprehensiveplanning was the only way to promote this strategy and that equity and plan-ning required tight controls over private economic activity. These beliefswere subsequently reiterated in the Industrial Policy Resolution of 1956,which became the "economic constitution" that guided the Government untilvery recently.1

1/ These policies, as stated in the Industrial Policy Resolution 1956 were asfollows: "It is essential to accelerate the rate of economic growth andto speed up industrialization and, in particular, to develop heavyindustries and machine-making industries, to expand the public sector andto build up a large and growing cooperative sector. These provide theeconomic foundations for increasing opportunities for gainful employmentand improving living standards and working conditions for the mass of thepeople. Equally it is urgent to reduce disparities in income and wealthwhich exist today, to prevent private monopolies and the concentration ofeconomic power in different fields in the hands of small numbers ofindividuals. Accordingly, the State will progressively assume apredominant and direct responsibility for setting up new industrialundertakings and for developing transport facilities. It will alsoundertake State trade on an increasing scale. At the same time as anagency for planned national development in the context of the country'sexpanding economy, the private sector will have the opportunity to developand expand..."

2.03 Planning was launched in the early 1950s and has continued eversince, with a hiatus in the 1970s when unsettled economic conditions forcedthe five-year Plans to be substituted by annual plans for a short pericd.India's planning was widely admired in the initial stages, and it was, interms of technical proficiency and internal consistency, an impressiveeffort. Its results were far less tmpressive. Apart from the difficultiesarising from developing the agricultural sector and the exigencies of war,fluctuating aid receipts and unreliable monsoons, the ambitious targets setby the Plans were waylaid by the basic strategy and its implementation. ThePlans sought to substitute for the market rather than to strengthen themarket's deficiencies. They tried to impose comprehensive controls on whatwas far from a true "command economy". What was within the government'sdirect control (public sector projects) was often poorly conceived and exe-cuted. Far more important, however, was the underlying approach of thePlans, viz. that self reliance had to be realized by massive import-substi-tution regardless of cost and to the neglect of exports; that import-substi-tution had to be led by the public sector; and that the private sector bad tobe highly regulated to make it conform to Plan priorities and socialobjectives.

2.04 The Indian interpretation of planned self-reliance was probablyunique among the early industrializers of the developing world. 'Selfreliance' is a nebulous concept which can be interpreted in many ditferentways. It could mean an open trading system or a closed one, and could in-clude an economy with fairly liberal policies to foreign technology and di-rect investment as well as one with extremely restricted policies. TheIndian version was the least open and liberal of the emerging NICs. Inconcert with a host of non-economic objectives, deep export pessimism and atraditional antipathy to large private business, this led inevitably to amassive array of government interventions in product and factor markets, withpervasive effects on exports, imports, industrial structure, technology,employment and competitiveness.

2.05 The nature and impact of these interventions on the industrial sec-tor is sketched in the following subsections. The essential points can besummarized thus. In product markets, the government intervened by severelyconstricting imports of all goods that were manufactured in India and"canalizing" a large part of imports through state agencies. It also con-stricted internal competition by allocating market shares among producers andby reserving markets for those assigned priority on non-economic grounds(public enterprises and small-scale industry). It fixed prices for a largenumber of industrial products to meet social objectives. In factor markets,it intervened in the allocation of investment resources, directing them intouses selected on non-market criteria, with a strong bias towards heavy indus-try and the public sector. It intervened in labor markets, in the setting ofwages, in the hiring and firing of employees, in their training and unioni-zation. Access to foreign inputs was almost as tightly controlled as accessto finished products, under the regime of wholesale import substitution. Italso intervened in technology markets, tightly controlling inflows of directinvestment and disembodied technology from abroad, funding large public sec-tor research and development institutions and stimulating R&D in privateindustry. The Government assumed, as in most other countries, primary

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responsibility for the provision of physical infrastructure and human capitalformation, a function which is discharged with less success than many otherNICs.

2.06 This pervasive regime of interventions had (in the terminologyexplained in para. 2.19 of Volume I), both functional and selective aspects.However, the promotion of economic efficiency, in the sense of ac.hieving thebest use of factors given the level of technology in international markets(i.e. reaching competitiveness), was not the main objective of theseinterventions. The interventions were not, in other words, designed tocompensate for market f%ilures that prevented industry from realizing itslong-term comparative advantage. They were designed to impose a structurewhich the policy-makers thought desirable (and presumably believed would beefficient as well as equitable) on a priori grounds, and which largelyignored considerations of international competitiveness and market-drivenincentives.

2.07 There was certainly selectivity, but it was not economic selectivityin the sense in which Korea exercised selective interventions. On the con-trary, Indian policy was basically non-selective: it did not gear interven-tions in the chosen sectors to bring them to international competitive levelsin a reasonable period with a mixture of protection, promotion, functionalsupport and institutional backup. The specific technological and skill needsof each activity did not govern the relevant interventions; nor were inter-ventions eased as industries matured. Some of the selective promotionalelements of Korea were certainly present, but not as part of a coherent,integrated strategy of achieving competitiveness. Indian industrial strategywas characterized by its broad (non-selective) scope, conflicting objectives,neglect of economic incentives, heavy weight of social considerations andpoor implementation of given policies.

2.08 The strategy waxed and waned over time in the details, stringencyand scope of its regulations, but was surprisingly consistent in its basicfeatures until the 1980s. The early part of the 80s witnessed some liberali-zation, and 1985 marked the start of a more determined phase of reducing someoi the pervasive controls and of counteracting some of its most damagingeffects. These reforms have, however, only dealt with some parts of theregulatory framework, as discussed below, and many of the traditional prob-lems of the Indian strategy still persist.

2.09 Turning now from the background of industrial policy to macro-economic performance, it is not surprising that the legacy of ths 1trategyadopted has been a fairly insipid record of growzh. Table 1 shows the growthof GDP and the major sectors from 1962/63 to 1989/90, divided into two mainperiods, and for the past 5 years individually. It also shows sectoralshares of GDP for three selected years. The performance of the economy nasimproved in the latter period (1976/7 to 1986/7) compared to the earlier(1962/3 to 1975/6), especially in the 1980's, but the overall growth rate hasnot been impressive, affording an annual average of 14 to 24 percent increasein per capita incomes. The manufacturing sector, however, has fared muchbetter in the 1980s. Since the mid-1980s it has recorded a series of in-creases unusual in the Indian setting, with the interesting feature thatagriculture fared very poorly until 1988. In the normal course of events

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this would have dragged down industrial growth after a short lag, but in thisrecent period manufacturing has forged ahead. A significant part of theexplanation clearly lies with the reforms of the time (on which more below).

Tie 1: INDIA; REAL GDP RWIOWTH RATES ANO VALUE ADME IN MAJOR SECTORS

Sectoral SharesCowth Ratas (Contl aPrices)

(Percent per a arc1962/3- 1976/7-1975/8 La 19861 JaI95/619I?L 191ML 19NILi 1k 1L2 /19AE21 19WI 11

Agriculture 2.5 2.6 0.8 -2.8 -0.5 17,4 0.5 80.5 86.0 81.8Industry 3.8 6.6 8.2 8.4 8.5 7.7 6.0 20.2 25.8 29.1Manufacturing 3.6 6.0 9.2 9.2 8.7 8.2 8.9 14.0 17.7 20.5

Services 4.4 5.9 7.8 :1.2 4.1 6.9 0.8 29.8 86 2 89.1Public Admin.and Defene i .OB A

CgP_factor cost i+ nN V 8~

Orowth rates calculated from logarithmic trend regressions.Quick eatimate.World Bank estimate.

Not* : %ata from *980/1 on:ard are from the 1980/1 base CDP estimates (revised) and arenot strictly comparable with earlie est!mates.

Source: 1989 CEM, p. 2, 1991 C84, p. 71.

2.1r The evolution of savings and investment since 1950/1 is shown inTable 2 as a percentage of GDP at market prices. The table also shows theshare of fixed capital formation accounted for the public and private sec-tors, and of gross domestic investment by industry and manufacturing. Thesavings-investment figures reveal a steady, and, for such a poor countryimpressive, improvement over the four decades in the resources devoted togrowth. The role of the public sector in fixed capital formation increasedover the 1950s and has fluctuated between around 40 to 50% since then, with adip in the early 1970s.

Table : INDIA: CROSS SAVINOS AO INVEST1fIET AS GOP(current prices)

1959./. 1955/6 19.69.1 19.45L6 1S901 1975/0 196Q/1 198ZL M193

Cross National Savings 5.2 6.4 7.6 11.7 17.0 32.8 21.2 20.7 20.5Cros Domestic Investment 6.1 6.8 0.6 13.8 18.6 85.8 22.8 22.5 23.6Cross Figed Capital Formation .2 L2 I s' au 9 L L ILI

0NPrivate Sector 76.9 58.5 51.1 50.5 61.9 59.1 65.5 61.6 49.9Public Sector 23.1 41.5 48.9 49.5 88.1 40.9 44.5 48.5 50.1

Industry as % CDI 14.6 29.8 86.2 40.8 87.2 86.6 45.6 48.8 n.m.(Manufacturing) (11.6) (19.2) (27.8) (27.9) (26.6) (27.5) (27.7) (27.4) n.e.

Source: Various C'Ma.

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2.11 The public sector has a savings investment gap of between 4 and 6Zof GDP in the late 1970's. In the 1960s this figure rose to around 7Z be-tween 1980-1 and 1983-4, and further to around 92 of GDP thereafter. Theprivate sector has generally saved more than it invested, and the surplus(around 6-72 of GDP in the past 5 years) has allowed the Government to fi-nance its growing investment program. Public savings have declined steaaily,from 4.62 of GDP in 1981/2 to 1.92 in 1987/8. There is a suggestion, there-fore, that the public sector is "crowding out" private investment, which hasstagnated (as a proportion of GDP) in the 19809 and has declined markedly(from 14.42 in 1985/6 to 11.7? in 1987/8) in the very recent period. Foreignsavinga have accounted for around 22 of GDP, financing 6 to 102 of grossdomestic investment in the 1980's. Their contribution to investment hasrisen since 1985, peaking at 102 in 1985/6, and declining slightly to 8.92 in1987/8.

2.12 Despite substanfial monetary expansion to finance the budget defi-cit, India has experienced relatively moderate inflation. The wholesaleprice index rose by 8.22 per annum during 196?!3-1975/6, 8.2% per annumduring 1975/6-1980 and 6.42 per annum during 1980/1-1984/5. Inflation stayedlow during 1985/6 (3.82) and 1986/7 (5.32), then rose to 8.2% in 1987/8, andslowed to 7.52 in 1988/9. The banking sector has continued to mobilizesavings successfully, offering attractive (real) interest rates and rapidlyexpanding its branch network. However, its lending is highly regulated.More than 402 of lending is mandated to "priority" sectors. Over 602 of thebanks' portfolio goes to the public sector, much of it at low rates. Arrearsare growing, with more than 102 of credit to industry and 462 of credit toagriculture in arrears. Recent moves to write off farmers' debts will onlyworsen this precarious position. (The financial sector is analyzed atgreater length in Section E.)

2.13 After a long period of fixed exchange rates, India devalued in 1966from Rs 4.76 to Rs 7.50 to the dollar. The devaluation followed the Bank'sBell Report of 1965 and consiCerable pressure exerted by the Bank and aiddonors on the Indian Government. It was meant to be part of a larger packageof liberalization, strengthening efforts which had started in 1962. Someliberalization did occur, but the additional aid promised did not materi-alize, and intervention levels rose again to high levels by the end of the1960s. Ir mid-1971 India adopted a floating rate pegged to a basket of cur-rencies. The exchange rate depreciated slowly over the next decade fromRs 7.4 to Rs 8.9 to the dollar (1971/2 to 1981/2), and reached Rs 12.97 in1987/8. In 1988/9 a more aggressive exchange rate policy emerged, and by end-1990 it had depreciated to around Rs 18.5 to the dollar. The real effectiveexchange rate (taking into account Indian and foreign inflation) improved forexporters in 1975. It stayed relatively constant the-eafter until 1985/6,but India actually lost competitiveness relative to other countries becausemany of them devalued faster than required by inflation. The recentdepreciation has helped to restore India's price competitiveness.

2.14 India's sluggish export performance has been one of the best knownfeatures of its development strategy. Total merchandise exports grew by 3.72per annum in real terms during 1965-80 and 3.62 per annum during 1980-87, farbelow the average for other NICs (7.72 and 8.42 respectively for the groupdefined as "exporters of manufacturers" in WDR, and 9.72 and 10.12 for East

Asia, including China). Manufactured exports have grown only slightly fast-er, though their share has risen faster since 1985. They comprised 45.1! oftotal exports in 1950/51, 47.7Z two decades later in 1970/71, 59.8? in1980/81 and 74.3Z in 1987/88. According to the 1991 CEM, the real growthrate of manufactured exports in the 19809 was as follows:

1980-81 1.5 1984-85 8.81981-82 3.4 1985-86 6.21982-83 -3.6 1986-87 11.21983-84 2.2 1987-88 26.1

1988-89 17.31989-90 (est.) 16.4

2.15 There was a clear improvement in the period after policy reformswere launched. The reforms were particularly directed to helping exporters(see below), bringing them nearer to a "free trade" regime of the type usedvery effectively by the East Asian NICs. The response was particularlymarked in the case of garments, gems and jewelry, and "other manufactures'(see Table 3). These are exports with 'easy' technologies, few economies ofscale and a measure of isolation from domestic demand. This enables them torespond quickly to changes in export profitability, in contrast to more com-plex activities where increases in exports require expansion of scale, im-proved technology ,: a concerted marketing effort.

Insa:i DoDA: COMOSTION OF KWeFACrUMPORTS(1 million current)

8ggfrdEgprts Iota I §4X A-W A-M~ LW, A-*~ Le LNJ 9N + ~4Leather Manufactures 478 454 408 44' e68 829 721 868 1,028 1.171Texiles 1,292 1,184 986 971 1,170 1.028 1.079 1,488 1,044 1,214Carant. 717 787 628 719 827 872 1,040 1 862 1,449 1 935Ces and Jewelry 788 909 1,054 1,258 1,041 1,228 1,622 2:018 8.086 8 178Enginering Goode 1,010 1,043 891 782 808 780 68 1.108 1680 1:998Petrofous Products 32 28 179 848 215 428 827 506 849 418Other anufactures 457 470 420 899 482 820 870 1.001 1.609 1.517

Surc: 1991 CEM, Statistical Anne%, Table 8.2(a).

2.16 This point is further illustrated by Table 4. This shows the rela-tive contribution of different categories of manufactured exports to the risein exports between 1980/81-1985/86 and 1986/87-1987/88. The total annualaverage exports in the second period was $2.5 billion higher than the first,and all of the increase came from manufactured products. Within manu-factures, however, nearly 70' of the increase originated in costsumptiongoods, led by gems, garments and leather. Engineering goods contributed only4Z of the increase, and chemicals and petroleum products another 16?.

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Table 4: INDIA: DECOMPOSITION OF RECENT EXPORT GROWTH(US$ million at current prices - annual averages)

1980/81- 1986/87- Contribution1985/86 1987/88 Increase to Growth

Manufactured Exports 5,260 7,760 2,500 1002

Consumption goods 3,390 5,110 1,720 69%Leather 500 800 300 12%Gems (gross) 1,050 1,820 770 312Garments 750 1,210 460 182Textiles 1.090 1,280 190 82

Investment goods /a 880 990 110 4Z

Intermediate goods 990 1,660 670 272Chemicals 370 550 180 72Petroleum Products 200 420 220 92

Others Lb 420 690 270 112

ja Engineering goods./b Including unclassified exports.

Source: 1989 CEM, Statistical Annex, Table 3.7

2.17 The role of foreign direct investment in India was negligible formuch of the period. According to balance of payments statistics, net di-rect investment inflows were zero in the 1970s and rose gradually in the1980s. The data are shown in Table 5. The inflows were clearly responsiveto the liberalizations that have occurred in this decade, especially since1985. However, their volume is still very small in relation to the size ofthe economy (in 1987/88, foreign direct investment accounted for only 0.42of gross domestic investment) or to inflows into other developing countries(in 1987, US$3.2 billion for Mexico, US$1.7 billion for China, US$1 billionfor Singapore, US$425 million for Indonesia, US$407 million for debt-strapped Brazil or US$418 million for traditionally selective Korea). AsTable C.1 Annex C of Vol. I showed, India has the lowest relative relianceon foreign investments of all the NICs.

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Table 5: INDIAt NET DIRECT INVESTMENT INFLOWS(US$ million, current)

1980-81 8 1985-86 1601981-82 10 1986-87 2081982-83 65 1987-88 2511983-84 63 1988-89 2991984-85 62 Total 1,126

Source: 1989 CEM, Table 1-5.

B. Growth and Diversification of Indian Manufacturing Industry

2.18 Indian manufacturing recorded respectable rates of growth until themid-1960s: the annual average was 7.6% for 1955-65. There was a markeddeceleration thereafter, with the 1965-73 period showing a growth of 4.02 perannum and 1973-80 of 4.9Z per annum. The 1980s witnessed a revival, and theaverage real growth rate for 1980-87 was 8.2% per annum (data from the Bank'sTrends in Developing Economies, 1989, p. 213). Table 6 shows annual changesin manufacturing value-added since 1977.

Table 6: GROWTH RATES OF MANUFACTURING VALUE ADDED

(Fiscal years)

1977 8.8 1983 6.51978 6.5 1984 9.91979 10.8 1985 6.61980 -1.7 1986 9.21981 -0.3 1987 9.31982 8.9 1988 5.7

1989 8.21990 3.9

Trend rates 1962/63-1975/76: 3.6Z p.a.1976/77-1986/87: 6.02 p.a.

Source: 1989 CEM, Vol. 1, p. 6.

2.19 There are two interesting aspects to the recent resurgence of indus-trial growth in India: first, in an economy accustomed to strong cycles inindustrial activity (as the figures for 1977-81 show), the current growth isunusually sustained. As noted earlier, it robustly survived an agriculturalrecession in 1986-87, an event which would normally have affected manufac-turing adversely. Second, it "seems to mainly reflect improvements in total

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factor productivity, rather than higher input growth" (1989-b, para. 1.16).This may be traced to several factors: better input supplies, easier accessto imported spares, the existence of previously underutilized capacity, moreexport rivalry, greater inflows of foreign technology and internal deregula-tion. Many of these factors were related to policy reforms.

2.20 The slowdown in industrial growth from the mid-1960s till the '80shas attracted a great deal of attention and analysis in India (see Ahluwalia,1985, for a valuable review and contribution). It seemed to be the result ofmany factors: infrastructural bottlenecks, slowdown in public investment;the accelerated emphasis on heavy industry and public ownership (with mis-managed public enterprises); worsening internal terms of trade for industryvis & vis agriculture; and a combination of inward-looking trade policies andstringent regulations on domestic competition and the labor market. Whilemany Indian analysts favor explanations based on "exogenous" factors such asinternal terms of trade, fall in public investment (even inequitable incomedistribution), the consensus among others (including the Bank) is that theslowdown was the inevitable "endogenous" result of the particular set oftrade and industrial regulations adopted by India.

2.21 The structure of Indian industry has changed significantly over thepast four decades, driven by the government's desire to build a self-relianteconomy, by maximizing the domestic provision of manufactured products.

Though there was a strong under-current of export pessimism (formalized inthe Mahalanobis planning model), the objective of self-reliance was autono-mous and of long standing. It entailed an emphasis on producer goods, tosustain growing investment and to provide intermediate inputs. It alsonecessarily meant foregoing the benefits of specialization and of enforcingthe market discipline that export-orientation could have provided.

2.22 The strategy did not evidently appear to the policy makers, withtheir physical planning approach, to lead inevitably to widespread ineffici-ency. Nevertheless, such a risk should have been evident on a priorigrounds. The domestic market could not provide the sort of competition thatexisted in international markets; potential internal competition and marketdiscipline were further constricted by several regulations. Nor could itprovide efficient scales of production in a number of heavy industries, whichwere extremely capital intensive and complex in their technology. The lackof specialization, the policy barriers erected to inflows of foreign tech-nology capabilities and inadequate R&D effort, could induce further techno-logical backwardness and incompetence in Indian industry. There were boundto be exceptions, because some firms or subsectors would respond to the spurto technological learning afforded by the protected market and the constric-tion on foreign investment and licensing. But these were bound to be theexceptions rather than the rule, because the more important incentives forlearning, arising form international or domestic competition, were absent orlimited. The Indian strategy, in other words, had a very different balanceof incentives from that provided by Korean policy makers (see the Korean casestudy), though both were highly interventionist and sought to protect local

industry and promote indigenous capabilities.

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2.23 The pace of structural change is shown in Table 7. The definitionsof the various categories are somewhat unusual. For instance, cars and bat-teries are counted as capital goods, while consumer goods include other con-sumer durables, 'basic' industries contain selected intermediates and elec-tricity. Nevertheless, it is apparent that "The goal of heavy indus-trialization and import substitution appear to have been achieved. Basic andcapital goods production have Lisen relative to intermediate and non-durableconsumer goods" (1987-a, para. 3.69). By any measure, India has an extremelydiverse and 'deep' (vertically integrated) industrial structure.

Table 7: STRUCTURAL CHANGE IN INDIAN MANUFACTURING (1960-84)(Z of output)

Index ofproduction fa

1960 1970 1980 1984 1985

Basic Industries 26.8 32.3 35.3 40.4 253.8Capital Goods 12.9 15.7 17.6 16.6 222.9Intermediates 24.3 20.9 19.6 17.8 181.0Consumer Goods 36.0 31.0 28.0 25.6 163.9

/a Base 1970=100, revised weights./b 'Basic' industries includes fertilizers, cement, pig ircn and

saleable steel, aluminium, electricity./c 'Capital goods' includes bearings, batteries, railway wagons,

passenger cars and trucks, tractors and other engineeringproducts.

/d 'Intermediates' includes jute manufactures, yarn, tyres as wellas petrochemicals and chemicals.

Source: 1987-a (CEM) Vol. II, Table 3.2, and Vol. III, Table 8.2.

2.24 The role of 'easy' import-substituting industries has declinedsteadily over the years. Thus, the share of the relatively mature and tech-nologically simple industries based on agricultural inputs (foods, beverages,cotton textiles, jute, tobacco) has fallen from 47.3% of the total in 1960 to24.5Z in 1984, while that of more complex metal based, chemical based ormultiple input based industries has risen from 52.7% to 75.52 (ibid., Table3.2). This conforms nicely to the Chenery prediction of structural changebeing accompanied by the greater "roundaboutness" (i.e. use of manufacturedinputs) of industrial activity (Chenery et al. 1986).

2.25 To enable a comparison to be drawn between the industrial structuresof India and Korea in the early 1980s, Table 8 rearranges the Indian dataalong the "light/heavy" lines used by the Koreans (see Table 3 of the Koreancase study). The comparison is subject to the qualification that the Indiandata are calculated as percentage of production while the Korean data are byvalue added. Nevertheless, it shows that India has indeed achieved a"heavier" industrial structure than Korea, but that the difference is not

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enormous. Korea (surprisingly) has a relatively larger food and beverageprocessing industry than predominantly agricultural India, and a smaller (butmore specialized and export-oriented) textiles and footwear sub-sector. Ithas larger chemicals, smaller metals and metal products, and about the samecapital goods, industries.

Table 8: COMPARISON OF RECENT INDIAN AND KOREAN INDUSTRIAL STRUCTURES(Z of MVA or Production)

(1) (2) (3)India (1980)

(I of Korea (1983) Difference

production) (Z MVA) (1 - 2)

Light Industry 40.2 46.1 -5.9Food, Beverage, Tobacco 8.9 20.0 -11.1Clothing, Textiles, Leather,

Footwear 20.2 13.2 7.0Other Light Industry 11.1 12.9 -1.8

Heavy Industry 59.8 53.9 5.9Chemicals 16.2 21.4 -5.2Basic Metals and Products I_ 19.6 9.5 10.1Transport Equipment 8.3 7.5 0.8Electrical, Non-Electr. Equip. } 8.5Electronic, Communication ) 15.6 6.4 0.1 bOther Equipment } _0.6

Total 100.0 100.0

ja Includes non-metallic mineral products for India./b Includes "Other equipment" for Korea.

Sources: India: 1989 CEM, Vol. II, Table 8.1(a).Korea: 1987-b report, Vol. II.

C. Market Structure and the Impact of Regulations

2.26 The market structure of Indian industry, defined to cover sellerconcentration levels, size distribution and ownership patterns, has beenstrongly influenced by government policies on entry, exit, small scaleindustry, public ownership and direct foreign investment. This sectionreviews briefly the evidence presented in recent Bank reports on these issuesand outlines the policies that have been relevant.

2.27 Let us start with concentration levels, measured in the conventionalmanner by four-firm concentration ratios. Table 9 sets out data for selectedindustries for 1983-84 and Table 10 shows the distribution of industries byconcentration ratios in India and, for comparison, some time ago (1963) inJapan. There is a wide range of variation in concentration levels acrossdifferent activities, to some extent reflecting inherent industrialcharacteristics such as the size of markets relative to economies of scal-

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and of product differentiation. Thus, food products, textiles, wood pro-ducts, and footwear have low to moderate levels of concentration, while scaleintensive (chemicals, rubber and plastic, metals and metal products, capitalgoods) or marketing intensive (beverages, tobacco) products have high levels.Given the small size of the Indian market for many modern manufactures, ahigh level of concentration relative to developed countries like Japan is tobe expected.

Table 9: INDUSTRIAL CONCENTRATION IN INDIA

Four-Firm Concentration Ratios, 1983-84

Consumer GoodsFood Products 13.6Beverages 62.3Tobacco 95.7Footwear 32.9

IntermediatesTextiles 23.1Wood and Cork 18.0Pulp, Paper Products 37.1Chemicals 50.7Rubber and Plastic 61.0Cement 41.2Basic Metals 50.4

Capital Goods and Consumer DurablesMetal Products 91.1Non-Electrical Machinery 72.8Electrical Machinery 72.8Transport Equipment 96.6

a The concentration ratios for selected industries werecomputed separately using industry sales data, bycalculating a weighted average for the sectors. Forexample, among the industries in the transport sector(i.e., autos, two-wheel vehicles, trucks, etc.), the(weighted) average four firm-concentration is 97%.

Source: Centre for Monitoring the Indian Economy, Marketand Market Shares, Bombay, March 1986, as shownin 1986-b, p. 33.

2.28 The high overall levels of concentration in India are, neverthe-

less, surprising in view of two important policy considerations. First,the government has sought to dilute the concentration of economic power inthe hands of large private industrial houses (MRTP firms) and affiliates ofmultinational enterprises (FERA firms). This has led to policies to holdback the growth of the larger units and promote medium and small units.Second, the Government has tried to promote internal competition in someindustries by deliberately fragmenting capacities via the licensing system.

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This has imposed high economic costs in industries where scale economiesare significant, but does not seem to have held back the forces making forhigh concentration.

Table 10: DISTRIBUTION OF INDUSTRIES BY FOUR-FIRMCONCENTRATION RATIO

India (1983-84) Japan (1963)Number of Number of

Concentration Industrial IndustrialRatio Segments Percent Segments Percent

0-19 10 9.2 157 30.720-39 9 8.2 142 27.740-59 15 13.8 117 22.860-79 15 13.8 50 9.8

80-100 60 55.0 46 9.0

Total 109 100.0 512 100.0

Sources: CHIE, Market and Market Shares, op. cit.; Richard Cavesand Masu Uekusa, eds., Industrial Organization inJapan, Brookings Institution, Washington, D.C., 1976.Taken from 1986-b, p. 35.

2.29 The impact of government intervention is thus difficult to interpretfrom the data. It is possible that concentration would have been even higherwithout intervention, and export orientation may have raised plant as well asfirm sizes to realize technical and marketing economies in world markets (ashappened in Korea with the chaebol). The adverse welfare implications ofconcentration in India arise not so much from the levels as they stand, butfrom the juxtaposition of concentration on a highly protected and internallyregulated industrial structure (1987-a, para. 3.83).

2.30 The size distribution of firms in India is shown in Table 11, andcompared to a number of other developed and developing countries in Table 12.Small firms in India (with under 100 employees) accounted for 21.42 of outputand 13.2% of value added in the mid-seventies, compared to 19.8% and 12.6Zrespectively in 1982/3. At the other extreme, large firms (with 1,000 plusemployees) accounted for 41.4% of output and 52.1Z of value added in thefirst year and 44.51 and 54.4Z in the second. Medium sized firms, withroughly one-third of value added, lost nearly 2 percentage points in theirshare over this period. The largest gainers were the biggest firms (5,000plus employees) in the country, again highlighting the failure of the govern-ment to meet its objective of diluting the power of large private companies.

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Table 11: MANUFACTURING OUTPUT AND VALUE ADDED BY FIRM SIZE

Firm Size Output Value Added(Number of Workers) 1975/76 1982/83 1975/76 1982/83

0-49 14.12 12.72 8.2Z 7.7250-99 7.3 7.1 5.0 4.9

100-199 8.2 7.7 6.8 6.3200-499 15.3 15.0 12.5 12.7500-999 13.7 13.0 15.4 14.0

1,000-1,999 16.6 15.5 18.5 14.72,000-4,999 13.4 12.7 16.7 14.85,000 and above 11.4 16.3 16.9 24.9

Source: Annual Survey of Industries, 1975/76 and 1982/83, shownin 1986-b, p. 30.

2.31 It is often noted that Indian industry has a relatively low repre-sentation of medium-sized enterprisest firms with 50-500 employees accountfor 302 of employment in India as compared to over 50% in the U.S., Japan,Taiwan or South Korea (figures quoted from a study by Little, Mazumdar andPage in 1986-b, page 30, footnote 29). However, in terms of the number ofenterprises clustered in the medium range (33-243 employees in Table 12),India's figure of 43.9Z exceeds that of the U.S. 36.5%, Jepan 17.62, Korea25.12, or China 40.2Z. It is not evident, therefore, that the claim of a"missing middle" is strongly founded; if anything, it is the small enter-prises that seem to be under-represented in India. The two East Asian coun-tries in the sample in Table 12, Japan and Korea, lead the others in thenumber of enterprise with less than 33 employees (80.22 and 70.72). Ofthese, Japan has a very strong subcontracting network, while Korea tendedmore to vertically integrated large firms (see the Korean case study), withits small firms operating autonomously in domestic or export markets (thoughexport sales are often made through large trading houses).

Table 12: SIZE DISTRIBUTION OF INDUSTRIAL ENTERPRISES(In percent)

Firm Size U.K. U.S. Japan S. Korea India China Yugoslavia Hungary(by empl oyees) (1979) (1977) (1972) (191) (197) (1982) (1981) (1981

6-33 66.5 68.4 80.2 70.7 61.7 69.2 6.6 2.288-76 16.8 20.3 10.7 14.4 35.8 19.6 16.8 4.876-189 10.8 12.4 6.1 9.2 7.8 12.2 82.1 16.7189-248 1.6 8.8 0.8 1.6 0.8 8.6 12.0 9.2248+ 6.9 7.1 2.1 4.8 4.4 0.6 838.6 66.1

Source: 1988-b, p. 81.

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2.32 Small enterprises in India have been strongly promoted by the IndianGovernment, not only by extension services, preferential credit and taxprivileges but also by reserving a large number of products for them. Whilethis has encouraged some efficient and dynamic SSIs and led to a thrivingnetwork of ancillaries (sub-contractors) around large engineering enterprises(Lall, 1980), it has also led to considerable inefficiency. It has "stimu-lated the replication of many production activities typical of larger unitson a smaller scale" (1986-b, para. 2.07). Fragmentation has sometimes been

carried to extreme lengths, with many SSIs being essentially unviable without

the strong reservation policies and other privileges. Many of the benefits

expected of SSI, in terms of employment generation and the efficient use of

scarce capital through more appropriate technologies, have also not been

realized (Little, Mazumdar and Page, 1987). SSI have often displayed ineffi-cient use of both capital and labor. With notable exceptions (gems and gar-

ments) they have also been unable to replicate the export success of their

counterparts in the East Asian NICs.

2.33 Finally, ownership patterns of Indian industry have been strongly

affected by policies on public enterprises and direct foreign investment. Itwas noted earlier that public ownership of the "commanding heights" of the

economy (i.e. basic industries) was a clear, long-standing objective of the

Congress party and the government. Various sectors (infrastructure) and

industries were reserved for the public sector or were earmarked for future

growth under public ownership. The cumulative value of investment in public

sector enterprises rose from Rs 9.5 billion in 1960/61 to Re 712.5 billion in

1987/8, with manufacturing enterprises (including power) accounting for

Rs 539 billion in the latter year (1989-b, Vol. II, Table 8.5). The share of

the public sector in manufacturing value added (MVA) went up from 72 in

1960/61 to 31% in 1983/84, and its share of gross industrial investment was

set at 40.6% in the Seventh Plan.

2.34 Public enterprises have benefitted not only from the reservation of

certain industries for their entry, they have also been shielded from direct

competition from the private sector in common activities (e.g. electrical

equipment) by demarcating product lines, privileged access to capital and to

public procurement and, more generally, by "soft budget constraints" which

permits them to be less profit-oriented (or more loss-making) than private

firms. At the same time, they have been burdened by more "social objectives"

and overmanning, unrealistic prices for their products, far less autonomy in

management and long-term decision making, often very poor project design or

implementation in highly capital intensive activities (and so high capital

costs) and the burden of carrying "sick units" which have been taken over

from the private sector (as in textiles).

2.35 The net effect of these privileges and demands has been poo overall

financial and economic performance. Numerous comparisons over time of public

and private sector capacity utilization, profitability, project imple-

mentation and the like have invariably favored the private sector. There

have been notable exceptions (such as the oil sector, or individual public

enterprises like BHEL and HMT) and public sector profitability has improved

in the past 2-3 years, but the general record has been insipid. This is

particularly significant in view of the fact that public enterprises provide

a significant proportion of inputs and equipment to other industries. Their

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inefficiency thus adds to the costs of downstream activities and may increasethe unreliability of their operations.

2.36 The small role of foreign investors in India has been noted above.Tight controls on new foreign entry, coupled wiLh FERA policies to induceexisting investors to dilute their equity holdings to 402 or below, have keptnew inflows to minuscule amounts till very recently. Table 5 had shownbalance-of-payments data on net foreign investment inflows, including rein-vested earnings of foreign affiliates in India. Table 13 shows approvals ofnew foreign investments by India, converted into U.S. dollars at the averageexchange rate of the relevant year. Only about 402 of approvals have re-sulted in actual investments in the past, so an optimistic estimate, based on50% of inflows materializing, comes to only $366.5 million for the period1970-88.

Table 13: FOREIGN COLLABORATIONS WITH EQUITY APPROVED, 1970-88(Value of Foreign Equity Approved, $ million)

No. of No. ofYear Cases Value Year Cases Value

1970 32 3.2 1980 73 11.31971 46 8.0 1981 57 11.91972 37 7.7 1982 113 65.21973 34 3.4 1983 129 59.01974 55 8.2 1984 151 90.81975 40 3.6 1985 238 103.61976 39 8.2 1986 240 81.51977 27 4.9 1987 242 83.61978 44 11.5 1988 234 160.21979 32 7.2 TOTAL 1,763 733.0

Note: Rupee values converted to dollars at average annual ex-change rates given in IMF, International FinancialStatistics (line ae).

Source: 1989-e, Industrial Technology Development Project,Annex 5, p. 1.

2.37 These data differ from those given earlier (Table 5), since they arebased on the (gross) value of approvals rather than net inflows, and excludeinvestments overseas by Indian enterprises. Surprisingly, the approvalfigures, even as they stand, are considerably smaller than the balance-of-payments based data shown in Table 5. For the past 9 years, the total ofapprovals comes to $667 million compared to $1,126 million for the data givenearlier. The difference may be due to different definitions of foreign in-vestments, but the basic point is strongly confirmed: whatever the measureused, India has marginalized the role of foreign direct investment in theeconomy.

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2.38 Turning now to the policies that have determined the structure ofIndian industry, the regulatory framework can be considered (following thecomprehensive review of the 1986-b study of this subject) under five areas(industrial licensing, MRTP regulations, small-scale industry, exit policiesand price controls).

(a) Industrial Licensing

2.39 The industrial licensing systen, covers capacity licensing, technol-ogy licensing and foreign investment licensing. A complex web of restric-tions, often cumbersomely administered, has been built up over time to meet avariety of economic and social objectives, some of which come into conflictwith each other. "Through capacity licensing, the government has attemptedto control the total amount of domestic capacity, as well as the allocationof that capacity among sectors, firms and locations. Industrial licensinghas been used to promote growth of priority areas of the economy while decen-tralizing plant location to "backward" regions and attempting a measure ofresource conservation through adherence to a physical balance between supplyand demand" (1986-b, para. 1.08). Licences are firm, product, time and loca-tion specific, stipulating the annual output of each product permitted toeach firm.

2.40 The legal framework for capacity licensing is the IndustrialDevelopment and Regulatory Act (IDRA) of 1951. IDRA laid down activitiesclosed to the private sector (Schedule A), activities where state ownershipwould increase progressively but private-state joint ventures would be al-lowed (Schedule B) and others open to private entry. IDRA has been modifiedover time to promote the growth of particular groups. Small and medium sizedfirms, with assets of below Rs 50 million, !o not need licenses for mostproducts. Some activities have been totally delicensed, while exemptions, topermit greater output of given capacities, to sh!-7t between products (broad-banding), or a certain rate of capacity increase and so on, have been made.The pace of liberalization increased in the 1980s. yet "The system of capac-ity licensing continues to function as a significant barrier to entry andgrowth for most firms outside the small-scale sector." The system is stillused essentially to guide resources into activities desired by the Govern-ment, according to Plan objectives, rather than into those with the highestrates of economic return or the potential for international competitiveness.

2.41 Apart from the direct effect on resource allocation, the detailedand rigid nature of licenses has restricted competition within India. Delaysin processing license applications have further deterred entcy and growth,while providing an advantage to applicants with established connections orresources to "work" the system. The desire of the government to lower pri-vate monopoly power (see below on MRTP) and to diversify location often ledto fragment capacity into uneconomic sized units. The system limited spe-cialization, inducing firms with growth potential to spread into unrelatedactivities, where they may have had little competitive edge, when constrainedfrom expanding in the original areas.

2.42 On the technology front, licensing policy has aimed at promotingself reliance in both the production of capital goods and the generation ofnew technology. This objective, again implemented with little explicit

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regard to economic efficiency or international competitiveness, was met byimposing a strict and cumbersome screening p.Tocess for importing technology,entering into a foreign joint venture, employing foreign technicians andimporting various categories of capital goods. The tightness of the screen-ing was increased over periods of foreign exchange shortage.

2.43 The Bank's (1987-b) study of industrial technology development inIndia comments on growing and widespread technological lags in Indian indus-try, with inadequate technological efforts by firms, outdated designs, poorquality and high costs in several subsectors. Part of the explanation lieswith regulations and controls that hamper competition, internal and external,in India, reducing incentives to firms to undertake technological effort.Part is due to inappropriate institutional mechanisma which have failed tostimulate technological effort by manufacturing industry and to bring aboutlinkages between the large science and research infrastructure and manufac-turers. And part is traced to policies governing technology transfer."Excessively bureaucratic procedures and restrictive regulations have con-tributed to a growing technology gap. By encouraging short-term agreementsand lump-sum payments, they have weakened the bargaining position of Indianfirms, narrowed the range of alternative arrangements for the acquisition offoreign technologies and increased the difficulties faced by small and mediumsized enterprises in importing technology." (1987-b, Summary, para. xii)

2.44 The entry of direct foreign investment has, as noted earlier, beeneven more tightly controlled. The internal growth of firms with over 402foreign equity has been constrained under the Foreign Exchange Regulation Act(FERA). FERA firms have been even more regulated that large domestic privatefirms (MRTP, see below), effectively closing a valuable avenue for the inflowof advanced technologies and the stimulation of domestic competition.

(b) MRTP Regulations

2.45 The MRTP Act of 1970 sought to contain the concentration of economicpower, prevent anti-competition practices and control unfair trading prac-tices. Concentration of economic power was equated to the growth of largefirms or business houses, and uncompetitive prices were seen as a naturaloutcome of such concentration. Thus, the implementation of the Act entailedthe mechanical application of criteria laid down to distinguish MRTP firms onthe basis of asset size or market share, rather than a case-by-case analysisof possible abuse of market power. In 1985 the thresholds for MRTP firmswere raised (for instance, a "single large undertaking" was defined as onewith assets of Rs 1 billion, or $77.8 million, rather than Rs 200 million),and the implementation of MRTP provisions was streamlined and somewhat liber-alized.

2.46 Nevertheless, the conclusion of the 1986-b study still stands:"Large firms have faced substantially higher entry barriers in comparison tothose outside the purview of the Act not only because of the lengthy clear-ance procedures for setting up or expanding a project, but also due to re-strictions on the scope of investment by MRTP companies. These barriers haveconflicted with the purpose of bringing a measure of competition to marketsdominated by large concerns. They have either blocked or made entry and

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expansion for large firms significantly more difficult in markets often char-acterized by high levels of concentration and possible excess profits ....[This] has possibly led to a further concentration of economic power by ex-cluding from the market the only firms which had the financial staying powerand technological resources to enter and compete effectively for the sharesof dominant firms. Thus, in the absence of trade competition and in view ofthe difficulties of bringing actual competition by enlarging the number offirms without a perverse efficiency tradeoff, MRTP barriers restricted compe-tition along its remaining dimension, that of potential competition or marketcontestability.0 (para. 1.28-29.)

2.47 The post-1985 liberalization has made expansion somewhat easier forMRTP (and FERA) firms, but the relaxation has been grudging and hemmed in bymany restrictions. Large firms, with their ability to internalize certainmarkets, bear risk and undertake expensive innovation or marketing, have anenormous potential for leading modern industrial growth: this potential hasbeen developed and exploited by Korea, but held back and suppressed by India.MRTP firms are still prevented from growing in many activities; more impor-tant, the governments attitude is still cautious and antagonistic rather thancooperative and supportive.

(c) Small-Scale Industry

2.48 India has long had one of the strongest promotion programs in thedeveloping world for SSI. This has included the reservation of a substantialnumber of goods (currently 863) for production by this group, excise dutyexemptions, investment and income tax concessions, freedom from private andproduction controls and from exit and labor restrictions, subsidized credit,and technical and infrastructural support. In the reserved list SSI hasenjoyed almost complete protection in the domestic market from large-scalefirms; in others, SSI has enjoyed various other advantages which have dis-torted competition. At the same time, the mode of implementation of SSIpolicies has discouraged the graduation of small firms to larger scales,since the privileges are contingent on remaining below rigidly specifiedsizes (in 1985 these limits were raised to Rs 3.5 million investment in plantand equipment for small-scale firms and Rs 4.5 million for ancillary, essen-tially subcontracting, enterprises). Since a number of reserved productshave been scale-intensive or technologically complex, the reservation policyhas held back the realization of economies of scale, the installation ofappropriate equipment or the undertaking of necessary technological effort."The result in many cases is poor product quality, lack of standardizationand quality control, and technological obsolescence." (1986-b, para. 1.32).

2.49 Government policies in the trade and industrial spheres (discussedbelow) clearly bear a significant part of the blame for the inadequate devel-opment of SSI in India. However, r. contributory factor may also have beenthe small base of skills available to SSI and insufficient institutionalsupport to meet their informational and technological needs. Despite India'simage as a country with abundant skill and engineering manpower resources,the country is in fact poorly endowed with such resources relative to theEast Asian NICs (see below). Large enterprises in the main urban centersattract much of the skill resources that exist (though here also doubts existabout the quality of training of a large part of the qualified manpower).

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SSI in smaller towns and rural areas seems to operate with little of thetechnically qualified manpower that is needed to develop competitivetechnological and other capabilities. The lack of skills also afflicts,along with other factors, the institutional framework set up to help SSI.

(d) Exit Policies

2.50 The regulations mentioned above restricted entry and competition inindustry; in addition, the government has imposed strong restrictions onenterprises leaving activities for which they have been licensed. Even theretrenchment of workers, mergers with or takeovers of other firms, or majorchanges of products or technologies, are difficult and cumbersome under theweb of policies that have grown in this area. These policies, aimed at pre-serving employment and conserving capital, provide "firms with insufficientflexibility to adjust to problems and insufficient encouragement to wind upoperations if they have lost their net worth". (1987-a, para. 3.146.) Theyserve to increase risks and lower expected returns to investments, whiledeterring entry from potential competitors and forcing employers to utilizeexcessively capital-intensive techniques. Progressively tighter restrictionson retrenchment and closure over the years probably contributed to the stag-nation in employment in the organized manufacturing sector in the 1980s(1989-b, page 112.)

2.51 The consequence of these exit and adaptation restrictions is thatthe normal morbidity of enterprises which is necessary for industrial dyna-mism is artificially retarded, and often painfully prolonged. As is wellknown, the Indian industrial landscape now abounds with "sick" firms: atend-1985, there were around 120,000 sick units, having risen by about 50%since 1983. Sick units tied down a substantial portion of bank credit, andposed a major policy problem to the Government. In 1985, it passed an Act tohelp with the worst cases of sickness, but its provisions were confined tocompanies whose net worth had already been completely eroded. It was alsotrying to coordinate closure or retrenchment policies with measures to re-train and re-employ affected workers, starting with jute, cotton textiles and

engineering, sectors with high levels of sickness (1989-b, para. 4.33).However, these measures are still tentative and have failed to make a realdent in the problem: the underlying causes of the exceptional rigidity inthe industrial structure have not been addressed. The approach remains oneof rehabilitating firms in trouble, "without sufficient regard to the oppor-tunity cost of resources allocated to the rehabilitation effort and the dy-namic impact of efficient resource mobility on employment creation" (1987-a,para. 3.66).

(e) Price Controls

2.52 Price controls have existed for a long time in India. A legacy ofthe Second World War, their scope was extended in the 1950s to a large numberof basic industrial products and mass consumption items. Prices have beenset, often on a firm-by-firm basis, by a cost-plus formula with an allowancefor "adequate" returns on investment. There are also different systems ofprice control, some applying to specified proportions of output to ensureallocation to priority sectors, some to ensure increased production (regard-less of producer efficiency) and some to hold down inflation. "The final

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result has been that, in many subsectors, price controls reduced profits tolevels that, in the past, discouraged entry, expansion and full utilizationof capacity" (1986-b, para. 1.48).

2.53 This concludes the brief review of industrial regu.ations and theirimpact on industrial structure. A later section (Section II.H) will returnto their effects on competitiveness and dynamism. The next section considersthe trade regime, which set the scene for domestic regulations and interactedintimately with it at all stages of India's post-independence development.

D. The Trade Regime

2.54 The persistent, pervasive and stringent nature of India's inward-oriented trade regime has long attracted critical analysis from the WorldBank, academic economists and, more recently, the Indian government itself.While this study cannot begin to do justice to the intricacies of the importand export regimes -- all extensively analyzed over time in Bank reports --it would be useful to highlight their main features as they affect industrialperformance.

2.55 Imports: In pursuit of self reliance, and impelled by growing for-eign exchange shortages soon after the launch of planned development, Indiadeveloped a system of import controls that have till recently virtually insu-lated domestic industry from import competition. Both tariffs and quan-titative restrictions have been deployed, the latter dominating the system ofprotection, with the former adding their impact to the products that cannotbe produced locally (in sufficient quantity) or that are needed for tech-nological upgradation. Even in this subsidiary role, tariffs are extremelyhigh in India. According to World Bank comparisons (1986-b, p. 47, and in1987-a, p. 95), Indian nominal tariffs on manufactured goods (unweightedmeans) in general are the highest of all the 10 countries considered (includ-ing China, Bangladesh and Argentina). They are also the highest in each ofthe three major product groups (capital, intermediate and consumer goods)with one exception -- China is 2 percentage points higher in consumer goods.

2.56 The Indian tariff structure is complicated by a large number ofexemptions, several of which are non-quantifiable, with the resulting inci-dence highly variable and ad hoc in nature. Many exemptions are introducedto enable particular industries, even firms, to obtain inputs or equipment atlower cost. "As a result of such specific exemptions, the identical productis frequently subject to widely varying import duty rates according to whichfirms or industry uses it, and for which purpose. This potentially generateslarge rents for the recipients of the exemptions. It also opens up profit-able opportunities for reselling products imported with low duties..."(1987-a, para. 4.40). To ccatrol such arbitrage, the Government hasinstituted detailed checks and controls, largely meshed in with the system ofimport licensing (below).

2.57 While the overall impact of exemptions is to substantially lowertariff incidence, tariffs remain relatively high even after exemptions.Table 14 sets out calculations of tariffs with and without exemptions for 10product groups in 1986 (only 30-40Z of exemptions could be quantified). Theduty collection rate, though lower than tariff rates, is also high: in

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1986/87, the import duty collection rate was 60.6Z on all imports and 62.9Zon imports excluding petroleum related products. In 1987/88, the tariffcollection rate was 65.42 on capital goods and 80.82 on intermediates (1990CEM). This rate is much higher tha other developing countries on which dataare available, some 24 times highea than the next highest country, Morocco(1987-a, para. 4.35). The difference between the rates shown in Table 14 andduty collection rates arises from non-quantifiable exemptions.

Table 14: AVERAGE CUSTOMS TARIFF RATES FOR MANUFACTURING SECTORS IN 1986

Weighted by 1983/84 imports(c.i.f. prices)

WithManufacturing Without quantifiable

Sectors exemptions exemptions

Food beverage and tobacco 231.4 168.2Textiles and leather 155.1 146.7Wood products 79.0 48.3Paper and printing 114.3 99.1Chemicals 127.5 114.1Refined petroleum products 140.0 0.0Non-metallic minerals 135.6 120.0Basic metals 171.6 143.6Machinery and metal products 134.8 122.8Other 110.4 100.1Average 147.0 90.7

Notes: "Average Customs Rates" are the sum of the ad valorem basicand auxiliary duties and do not include countervailing (addi-tional) duties. They also do not include the (relativelyfew) specific duties. Only about 30-401 of exemptions couldbe quantified, i.e. associated with reduced tariff rates forparticular BTN (Drussel Tariff Nomenclature) products.

Source: 1987-a, p. 96.

2.58 The final outcome is a tariff structure of enormous variability,complexity and non-transparency. The widespread exemptions do not serve toexpose Indian producers to greater international competition, for two rea-sons. First, tariffs are, as noted, only a subsidiary element in thestructure of protection. Second, tariffs are administered so that "importsof products not made in India are allowed (often under Open General License)and lower tariffs charged, whereas imports are typically blocked or re-stricted and high tariffs maintained if there is local production capacity"(1987-a, para. 4.35). Moreover, the general levels of tariffs have increasedsince the late 1970s, though the number of products given exemptions was alsoincreased. The net effect, as measured by duty collection rates, has been arise in tariffs, though the increase seems to have been driven by a desire to

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raise revenue ratb - than to further raise levels of protection. However, asthe 1987-a report concludes: "the increased general level of tariffs and thegreater dispersion resulting from exemptions has increased the variability ofavailable effective protection and has correspondingly increased the ineffi-ciency with which the tariff system allocates resources, and to this extentwould increase the difficulty of moving to a more uniform system of r-otec-tion." (para. 4.46). The 1990 CEM notes that tax exemptions and drawbacksattract a lot of rent-seeking activity because they remain major determinantsof the financial viability of activities (para. 2.68).

2.59 Quantitative restrictions, the main system of protection in theIndian system, take four main formst import licensing, canalization, the"actual user" policy and phased manufacturing programs. Under the importlicensing policy, the import of consumer goods has been generally banned forseveral decades, with the exception of certain essential products (edibleoils, kerosene, some drugs and foodgrains) for mass consumption, which arecanalized. Capital goods are either restricted or under Open General License(OGL); the latter can be imported without a license if the importer is an"actual user" and if the equipment is compatible with domestic licensingpolicy. All non-OGL equipment imports have to be licensed. Intermediategoods imports are 'banned', 'restricted', 'limited permissible' or OGL (whichcomprises all products not under the first three categories, and which has an"actual user" requirement). It is the OGL element of capital and intermedi-ate goods, subject to the restrictions noted and the tariffs imposed, thatconstitutes the liberalized segment of Indian import trade.

2.60 The licensing system is highly discretionary, with each applicationtreated on a case-by-case basis. Each import has to be "essential" and havean "indigenous angle clearance", which means that a product of satisfactoryspecifications and quality cannot be locally supplied in reasonable time --costs are not usually considered. Thus, "import licenses are generally allo-cated in a non-price, administratively -- ad hoc manner" (1987-a,para. 4.12).

2.61 Canalization is effected through 16 government agencies with thesole right to import specified products (largely bulk intermediates and rawmaterials); several exports, of similar products, are also canalized (about112 of total exports). Canalized imports account for about 43? of totalIndian imports including petroleum oil and lubricants (POL) or about 35% ofimports excluding POL products (1990 CEM). The proportion of canalized tototal imports rose during the 1970s but has declined in the 1980s, as aresult partly of "decanalization' (most importantly, of cement) and partly ofchanges in import composition. There has been much criticism within India ofthe costs and rigidities introduced by the canalization system.

2.62 The "actual user" policy confines imports to those who will directlyuse them in production. It prohibits imports for resale to prevent tradersfrom exploiting the rents inherent in the protective regime. Some exceptionsare allowed for intermediaries to import on behalf of a number of firms or bycombining replenishment licenses earned by exporters. However, the systemhandicaps imports of equipment and intermediates by small enterprises or for

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small orders even by large firms, because it greatly raises transactionscosts for small sized imports (1987-a, para. 4.17). The actual user policywould thus prevent most consumer goods imports even if the present ban werelifted.

2.63 Phased manufacturing programs (PMPs) govern the increase in localcontent as an accompaniment to the granting of an industrial license. Theyact as a non-tariff barrier to imports, stretching indefinitely over time andapplying even to OGL goods, since the import of all components and parts issubject to prior clearance to ensure adherence to the relevant PMP. PMPs arebeing used with greater frequency in recent years, running counter to thetrend for easing restrictions on imports of intermediate goods. Their great-er use is especially marked in new industries such as electronics and pharma-ceuticals and as part of modernization in transport ar machinery industries.

2.64 In addition to the four major instruments of import control, variousaspects of the industrial regulatory system and government procurement alsoact as significant import barriers. The import of capital goods, for in-stance, has to be cleared by a Capital Goods Committee, which can protectdomestic producers of equipment against imports even if they fall under OGL.Technology import policies, considered later, also serve as barriers to capi-tal goods imports when these are part of technology imports. Official pro-curement gives preference to domestic firms, as in other countries.

2.65 The present quantity restriction (QR) system has been in place since1956, and has undergone periodic relaxation and tightening in response to theforeign exchange situation. The past decade or so is, in general, a periodof relaxation, but in very selective and cautious terms. Consumer goodsimports remain banned. Capital goods have been steadily liberalized since1976 by increasing the number of OGL items, from 79 in 1976, to 1,170 in 1988(in the latter period there were 154 items on the restricted list). Most ofthe OGL items were not generally produced in India, and were shifted to en-able particular sectors to modernizes over time, however, there has beenincreasing competition for some capital goods producers (e.g. machine tools,chemical and leather machinery, food processing equipment). This increasehas been accompanied by reduced stringency in the application of discretion-ary controls. Thus, a "global tender" policy was introduced in 1978 to allow13 industries (including power, fertilizer, petrochemicals, petroleum, sugarand cement) to call for worldwide tenders for capital goods. However, thiswas implemented in a way that tenders were called only for those projectcomponents which the Government decided "could not be satisfactorily suppliedby local firms' (1987-a, para. 4.24).

2.66 A "project import" policy allows for capital goods imports at re-duced tariff rates. These rates were slashed in 1985 and increased importswere allowed in such items as boilers, and generators for the fertilizer andpower industries, providing increased competition to local engineering firms.In 1985/86, project imports came to 10.7Z of total imports and to 69% ofmachinery imports, equal to about 152 of the value of capital goods produc-tion. 'However, these imports are at the discretion of the licensing author-ities, and the present apparently fairly liberal approvals of import applica-tions could easily be reversed. Customs duties on machinery imported forprojects were substantially increased in the March 1987 Budget." (1987-a,para. 4.24).

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2.67 Intermediate goods imports have also been steadily shifted frombanned/restricted lists to OGL since 1977. But this is not a clear indica-tion of import liberalization, and most commentators agree that the mainobjective "has been to ease the supply situation of important non-competitiveinputs used by domestic industries" (ibid. para. 4.25). Thus, the finalcompetitive impact on domestic industries has been limited, though there hasbeen some indirect competitive pressure (through substitution). In fact, bymaintaining protection of final products, the easing of imports of inputs andequipment (combined with tariff concessions) has increased levels of effec-tive protection to several industries, e.g. electronics.

2.68 Another source of increased import competition has been imports ofotherwise restricted-intermediates under REP (replenishment) licenses givento exporters (see below). This has "given the import control system a highlydesirable degree of flexibility by reducing the incidence and severity ofscarcities resulting from rigidities and mistakes in the administration ofimport licensing" (ibid., para. 4.26). However, "allowing for the fact thatalmost half of the value of imports under export-related import licenses arerough diamonds, while others are agricultural raw materials such as naturalrubber, the potential competition from this source for local producers ofindustrial intermediate goods is probably equivalent to less than 10Z oftotal non-POL imports" (ibid.).

2.69 Taking into account all the changes brought about by recent policychanges on imports, the 1987-a report concludes: "In fact the share of trulyunrestricted imports directly competitive with domestic manufactured productswere probably confined to a small part of OGL imports, probably equivalent tofive percent or less of total non-POL imports" (ibid., para. 4.29). Thisimpression is confirmed by a 1986 survey of 32 engineering firms supposed tobe subject to intense import competition. With the exception of machine toolproducers, none of the firms felt their products to be subject to competitionfrom OGL imports. Thus, while some liberalization did take place, its directimpact in the competitiveness of Indian industry was marginal, and concen-trated in a few subsectors (essentially some machinery and chemicals). The1990 CEM notes that "there appears to be a tendency to move items off OGLwhen domestic production starts." (para. 2.54).

2.70 Exports. Of the many reasons for the poor export performance ofIndian industry, three are highlighted in the Bank's (1987-d) study of exportdevelopment. The first is the high cost of industrial inputs, affectingproducers' competitiveness despite compensatory mechanisms. The second isobsolescence of product design and quality and outdated nature of processtechnology in use in many industries. The third is the inability of theexport promotion schemes of the time to offset the negative effects of thepolicy environments they lack the necessary flexibility, automaticity andefficiency (1987-d, Vol. I, p. ii). The combination of import protection,internal regulations and insufficient export incentives have led to an uncom-petitive and obsolete industrial sector aimed increasingly at the sheltereddomestic market, and to export profitability declining markedly in the 1980s.In addition, some exports were canalized, as noted, and some were subject toexport restrictions to keep domestic prices low.

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2.71 Indian export promotion policies are numerous and extremely complex.They are of 6 types (1987-a, para. 4.51)t

- Special facilities to make imported inputs available toexporters at reduced cost;

- Free trade zones and bonding facilities;- Subsidies on domestic raw materials;- Facilities for acquiring imported equipment at reduced

cost;- Incentives and assistance for export marketing;- Profit tax and credit subsidies.

These facilities have been improved and extended since the late 1970s, withthe effort accelerating in 1985. In particular, the exchange rate has beenused more flexibly to promote exports, and the real effective exchange ratewas depreciated by over 302 between end-1985 and end-1988 (1989-a,para. 206). Other schemes were streamlined and extended, especially theprovision of imported inputs and the refund of excise taxes as domesticinputs. Many of these measures were apparently taken at the suggestion ofthe Bank's export development study (1987-d).

2.72 The various export promotion policies may be briefly described. Theschemes to provide inputs to exporters are basically the replenishment (REP)and imprest license, combined with duty drawback and cash compensation. REPlicenses can be sold on open markets by exporters who receive them, theyearned large premia during the 1970s; but the premia have declined sub-stantially in the 1980s. In 1988 the REP scheme was extended to any canal-ized/restricted item. Drawbacks cover import duties and internal excisetaxes. The cash compensatory support scheme, involving the largest singlebudgetary outlay in support of exports, is supposed to compensate exportersfor other indirect taxes not covered by drawbacks. To reduce delays in ob-taining duty drawbacks, the government introduced advance licensing in 1978and an Import-Export Passbook Scheme in 1985. These schemes were also im-proved and extended in 1988, and, by 1989, "almost all inputs are importableby exporters without restrictions and payment of duties." (1989-a, para.2.05.) The scheme had been extended to indirect exporters and rendered moreflexible.

2.73 There are two free trade zones (FTZ) in operation in India and fourmore are being launched. The bonded (or 100Z Export Oriented Unit, EOU)scheme was launched in 1981. Neither have been very successful. wThe EOUsare hindered by an onerous and obsolete customs control system, by excessiveand unnecessary bonding requirements and by excessive regulatory restrictionson their flexibility. The FTZs to a lesser extent are also subject to com-plex procedures and paperwork, and are burdened with competing objectives"(1987-a, para. 4.59). The incentives and facilities offered are uncompeti-tive with other FTZs in existence, and few foreign firms have located inIndia for offshore processing activity.

2.74 The scheme to refund exporters the difference between domestic andworld prices on domestic inputs was launched (for steel) in 1981, and laterextended (to rubber, copper, aluminium and basic petrochemicals). This isparticularly valuable to small exporters, but problems exist in calculating

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the correct amount of compensation. Moreover, there exists the danger thathigh cost domestic inputs will be utilized for exports at an economic loss toIndia.

2.75 A major aim of liberalization of capital goods imports has been toprovide export oriented industries with modern equipment at lower prices. In1986 the scheme was broadened to include a range of "thrust industries' (i.e.those believed to have future export potential). Tariffs on the relevantequipment was cut to around 25-35%; special allowance was made to majorexporters to import even locally available capital goods, and flexibility inthe use of REP licenses to include equipment was broadened (1989-a, para.2.16). However, this poses a policy dilemma in that local capital goodsproducers, faced with high input prices, may be given negative effectiveprotection by these measures, and suffer an unwarranted loss ofcompetitiveness.

2.76 To assist export marketing by small and medium sized firms, thegovernment has permitted intermediaries to enter import/export trade and hasencouraged the development of Japanese or Korean style large trading houses.Exporters have also been given easier access to foreign exchange for travel,commissions and so on, and are now allowed to retain 5-102 of export earningsfor this purpose. An Export Marketing Fund was established in 1986, and 18industry-specific export promotion councils have been in existence for sometime. Five regional export inspection agencies have been in operation since1963. Despite all these efforts, "the impact on exports has been diminishedby extremely detailed conditions and controls and the delay-prone proceduresimposed..." (1987-a, para. 4.63). The Export Promotion Councils have beenrelatively ineffective and the export inspection system costly and counter-productive (ibid). In view of the other substantial improvements in exportpolicies, marketing support remains a serious area of weakness, one which arecent Bank project (Export Development, 1989-a) seeks to help remedy.

2.77 Tax concessions have been given to exporters since the early 1960s.They have been increased re-ently, so that at present all profits fromexporting are tax free. There are also provisions for credit at preferentialinterest rates, which would amount to a subsidy of about 7.22 of the f.o.b.value of exports if used for the maximum period of 180 days. The Export-Import Bank provides subsidized credit for capital goods and project exports.Long-term financing for exporters at 20% lower interest has been made avail-able since 1986 to firms exporting over 25Z of their output. There stillremain important gaps in the system of export finance, due to poor managementin banks, inappropriate lending guidelines and delays in processing (1987-a,para. 4.65). This is also sought to be remedied in the new Export Develop-ment Project.

2.78 The 1987-a report sums up on the recent export promotion measuresthus: "None of these measures are ideal, and involve costs in terms of otherdesirable reforms, but the incentive and signalling effects in favor ofexports are unmistakable. These and other recent decisions give an impres-sion of greater energy, determination, and commitment to exports than Indiahas witnessed before" (para. 4.67). The positive response of exports tothese various changes was noted earlier. It is encouraging that the momentumof export growth has been maintained: in rupee terms, exports grew by over25Z in 1988/89 and 332 in 1989/90. But much remains to be done to streamline

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the schemes and their implementation, and the underlying constraints on com-petitiveness take time to remove. What the measures seem to be achieving istaking up the slack present in the system (by firms which are already com-petitive, or can become so with minor improvements), especially in light,"easy" segments of manufacturing (gems, textiles, garments, leather goods andsome engineering products).

2.79 To conclude on the trade regime, Indian policy has effectivelyinsulated most of the manufacturing sector from direct import competitionand, until recently, minimized the incentives for exporting for most of manu-facturing industry. In concert with internal regulations, barriers to theentry of foreign investors and other controls on technology imports, this hascreated a tightly constrained environment for Indian enterprises. Thisenvironment shelters them from foreign and (to a lesser extent) domesticcompetition, information flows and technological trends; at the same time, itprovides a cushion for undertaking the complex and costly task of masteringnew technologies, considerable impetus for substituting local for foreignmaterials and components, for down-scaling technologies, and for "making do'with older vintages of equipment and technologies.

2.80 Since very few industries are highly export-oriented, in the senseof devoting a major part of capacity to foreign sales, the influence exertedby the (often very different) domestic market tends to predominate in thedesign, performance and other characteristics of Indian manufactures. Thus,it is mainly in products where designs are easy to adapt and information easyto transmit (garments, textiles, leather products), or where they are fairlystandardized (gems, simple equipment, some intermediates), that Indian firmsare able to react quickly to export incentives. In others, where adaptationto foreign markets would be difficult or expensive, the prolonged inward-orientation of the economy has created a heavy overhang which can only beremoved after a lot of effort. This is in addition to the normal X-ineffici-ency (managerial slack), insufficient technological effort for cost reductionand lengthening lags behind world frontiers also created by the controlregime.

E. The Financial Sector and Industrial Finance

2.81 India's financial sector has functioned over the past 40 years undera regime of very tight controls. Nevertheless, considerable success has beenachieved in raising the savings rate as well as in the financial mobilizationof savings. India's national savings rate has been in the 22-24% range inthe 1980s, a relatively high savings rate for a developing country with a lowper capita income. Households savings form the major part of savings,ranging from 15% to 17% of GDP in this period. Net household financialsavings account for about 502 of household savings, indicating the financialsystem's success in mobilizing resources. The broad money stock2 now amountsto about 45% of GDP compared to the 24% to 272 range prevailing in the early1980s, again indicating a high degree of financial deepening. Recent Bank

2/ Defined as currency held by the public plus demand and savings deposits incommercial banks. Includes government, business and household holdingsand thus are not strictly comparable with the savings flow of households.

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studies suggest that the level of real interest rates, maintenance of infla-tion at single digits, spread of bank branches in rural areas, shifts inincome distribution, favorable taxation of financial instruments and otherfactors have contributed to the high savings rate and financial development.The financial deepening appears to have taken place in the metropolitan andurban areas rather than the rural areas. In addition, some deepening may beattributable to the remittances from Indians working abroad.

2.82 During the past seven years, private sector savings has increasinglyexceeded private sector investment. This rising private sector surplus, plusa higher rate of foreign savings provided the financing for an increase inpublic sector investment in spite of declining public sector savings. Thegrowing private sector surplus reflects not only rising private savings but aslightly lower rate of private investment compared to the beginning of thedecade which may be the result of some 'crowding out" of private investmentby the public sector. The mechanisms for this "crowding out" have been highreal lending rates, controls on banks' portfolio consumption and tax conces-sions that diverted private funds to public sector debt. The latter wasparticularly evidenced in the reduction of private debenture issues in1987-88. The decline in public sector savings largely reflects the erosionin Central Government savings which was about -2.5% of GDP in 1986-87.

2.83 With regard to resource allocation, the Reserve Bank of India (RBI),the Central Bank, has maintained strict control over credit allocation untilrecently when some relaxation took place. Interest rates have played a minorrole as an allocation device but rather functioned as a distributional deviceto lower the cost of credit to the Government and priority borrowers.Currently, about 65Z of commercial bank funds are subject to government-dire.ted credit allocations. Required investment in Government debts formsthe largest portion of government-directed credits; their size and growthreflects thc growing deficit financing need of the Government. Theserequired investments comprise (i) a cash reserve requirement with the RBI and(ii) a statutory liquidity ratio (SLR) requiring a certain proportion ofdeposits to be invested in Government bonds and other eligible instruments.The SLR clearly represents a mechanism to channel resources to favored usesat below market rates. State Governments and public sector enterprises areestimated to absorb 25% of commercial banks credit. A substantial part ofthe remaining resources are targetted for specific uses by RBI. Fortypercent of a commercial bank's portfolio currently must be loaned to prioritysectors, mainly agriculture and small scale industry. In addition, about 10Zof credit went for food procurement during the 1980s. Thus, banks canallocate only 25-30Z of their resources after cash reserve, statutoryliquidity, priority sector and food procurement requirements are satisfied.The medium and large-scale industry sector has been the principal loser inthis reallocation of commercial bank credit. Its share declined from nearly452 of total commercial bank credit in the 1970s to between 33Z and 35Zduring 1983-87. This reallocation plus the high cost of non-priority fundshas caused larger industrial firms to switch to the capital and moneymarkets.

2.84 In addition to sectoral allocations, interest rates on loans are setby the RBI. Until recently, a ceiling rate limited the maximum interest rate

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that could be charged by a commercial bank. This has been recently sup-planted by a floor rate currently set at 16? (effectively a prime rate) withhigher rates for riskier loans. However, there are preferential ratesapplicable to priority sectors of lending, e.g., small scale industry (12Z to14Z) which reduce the actual spread available to the banks.

2.85 In spite of the fact that interest rates, including rates charged topriority sectors have been appropriate (positive in real terms), it appearsthat credit allocation policies in conjunction with industrial and tradepolicies contributed to a high degree of financing of inefficient invest-ments. The portfolio of commercial banks are particularly affected byarrears of sick companies and non-performing agricultural loans which havetied up a substantial volume of resources. As of December 1986, commercialbanks' credits of Rs 49 billion were officially classified as being extendedto "sick industries, which have negative net worth. Outstanding credit tosick industries alone were about 15.7% of commercial banks' credit to indus-try and 8.1% of their total outstanding credit. The situation in theDevelopment Finance Institutions (DFIs) is similar; in 1985 the IndustrialDevelopment Bank of India's (IDBI) outstanding loans to sick industries wereabout 112 of its portfolio. In addition to the sick industry problem, thecollection ratios on other industrial and agricultural lending have beendecreasing. The problems are being further exacerbated by increasedcompetition faced by many industries resulting from the ongoing industrialliberalization. In recognition of these problems, the Government has since1985 set up several committees to study the various financial markets andrecommend ways of improving the working of the financial sector, and theirreports are providing a basis for an ongoing process of reform.

Industrial Finance

2.86 Indian industry is financed through a complex and sophisticatednetwork of institutions and a rapidly growing capital and money market. Dur-ing the 1980s there has been a noticeable shift in the pattern of corporatefinancing, particularly of large ectablished firms, away from commercialbanks and specialized financial institutions to direct savings mobilizationthrough the capital and money markets.3 Regulatory constraints on commercialbanks, the increasing size of projects financed which often exceeded themaximum exposure limits of individual institutions, and the freedom of firmsfrom supervision by nominee directors from the develonent banks and thethreat of "partial" nationalization through the conversion clauseconditionality of development banks have also influenced this trend. Areview of the sources and uses of funds for 417 large non-government firms inICICI's portfolio, between 1979-87 indicates that long-term borrowings from

3/ This trend has come about partly from private savers changing preferencefor holding savings increasingly in the form of shares, bonds and mutualfund units rather than as bank deposits. Private households' holdings ofsuch market instruments as a percentage of their total financial assetsincreased from 3% to 6.7% between 1978-79 and 1986-87. During the sameperiod their holdings of bank deposits as a percentage of total financialassets declined from 51.3% to 46.7?.

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financial institutions and banks which averaged 9.5% of total funds in1979-81 declined to about 4.7Z in 1984-85 although the share increased to8.8? in 1987-88. The major funding shift has been to debentures whichconsistently increased their share from 1.7Z in 1979-80 to 22.1Z in 1986-87.

2.87 Commercial banks are a major source of finance for industry, par-ticularly for working capital. For the small scale enterprise sector, theyare also a substantial source of term finance for fixed investment. In the1980s, about half of the total counercial bank credit has been allocated tothe industrial sector although the share of medium and large scale firms hasbeen declining. At the end of 1988, outstanding industrial credit from com-mercial banks was about Rs 360 billion compared to the total outstandingassets of IDBI, IFCI and ICICI (the three All-India development banks), whichwas about Rs 175 billion. In 1987-88, commercial banks' net increase in bankcredit to industry was about Rs 50 billion compared to total disbursements byall specialized financial institutions of about Rs 63 billion.

2.88 Besides commercial banks, the long-term financing needs of mediumand large-scale private industrial firms are served by four DFIs headed bythe IDBI. The others are ICICI, IFCI, and the Industrial Reconstruction Bankof India (IRBI). Although the newest of the DFIs, IDBI acts in an apex andcoordinating role and a substantial amount of its lending involves refinance.It also holds equity positions in IRBI, IFCI, the Unit Trust of India (UTI),a mutual fund organization, and state level financial institutions. At thestate level, State Financial Corporation (SFCs) and the State IndustrialDevelopment Corporations (SIDCs) are the counterparts to IDBI at the nationallevel. The main shareholders of the SFCs are the state governments and IDBIand they receive most of their resources from IDBI, the Central Governmentand Reserve Bank of India (RBI). The SIDCs are promotional agencies of thestate governments and provide both term loans and equity. IDBI providessubstantial resources to the SIDCs. The Export-Import Bank of India, set upin 1982 to take over the export credit functions of IDBI, is also involved inexport promotion through the management of an Export Marketing Fund.

2.89 In addition to the above-mentioned DFIs, the Life Insurance Corpora-tion of India (LIC), and the General Insurance Corporation of India (GIC) arealso increasingly involved in term finance of industry although a substantialpart of both institutions' resources are required to be invested in Govern-ment securities and other approved investments. Much of their funding forindustry goes through the capital market where they are important net buyersas well as underwriters but they are also direct participants in loans of theDFIs. Some of their investments consist of obligations of the All-IndiaDFIs. LIC and GIC are also engaged in short-term investments. Finally, theUTI, a mutual fund founded in 1964 by the RBI in association with LIC andcomercial banks is also a major provider of finance to industry through thestock market where it has become a dominant buyer along with the GIC and LICas well as in direct cofinancing of loans with the DFIs. In recent years,UTI has also increased its participation in short-term financing.

2.90 It is estimated that the share of the specialized financial institu-tions in financing gross fixed capital formation4 in the private sector

4/ Refers to expenditures in machinery and equipment only.

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(including corporate, cooperatives and households) has increased from about16Z in 1980-81 to 23.62 in 1986-87. Given the trend towards the use ofcapital and money market facilities by larger established firms, this sug-gests that a growing percentage of institutional lending is being channelledto medium-sized enterprises; this trend is particularly evident in the caseof IDBI. The development banks' assistance through underwriting/direct sub-scription have been primarily for equity/preference shares whereas theinvestment institutions (LIC, GIC, UTI) have provided support mainly fordebenture issues.

2.91 The entire term finance system is under the coordination of IDBI.In addition, IDBI provides resources to State level institutions, which havebecome dependent on IDBI refinancing for more than 60Z of their operations.After adjustment of inter-institutional flows, IDBI's share of total creditgranted by term financial institutions (net of IDBI's refinancing and billdiscounting activity) was about 40Z in 1987/88. The shares of the other All-India institutions are currently about 11% for ICICI, and 9.5? for IFCI, with17.6? accounted for by the three investment institutions (UTI, LIC and GIC).The State level institutions contribute to total institutional assistancewith 23?.

2.92 The All-India DFIs and banks have adopted uniform business andoperational policies with regard to term industrial finance, which arefurther cemented by consortium arrangements for large project financing, andby collective consensus decisions on credit matters at different levels. Thefinancial institutions maintain close working relationships with each otherin all matters relating to policy formulation, sectoral strategies, pro-cedural improvements, project appraisal and follow-up.

F. Technology Policy

2.93 India was perhaps the first developing country to launch a compre-hensive and long-term plan for indigenous technology development. Given itsstrategy of industrial self-reliance, the fostering of local technologicalefforts, even as a follower rather than a leader, was imperative if Indianindustry was to assimilate, adapt and build upon new technologies. Thus,Obeginning in the early 1940s, but principally since independence, a widearray of institutions have been built largely within the public sector tosupport the development and diffusion of technology. Their activities encom-pass virtually all those generally found in the industrialized countries andadvanced NICs. They now include a Ministry of Science and Technology, overone hundred research and development (R&D) institutes, as well as institu-tions responsible for: standards and production certification; patents andother forms of intellectual property; technology diffusion to small-scaleindustry; technical consulting at the state levels and regulating the inflowof foreign technology" (1989-e, para. 3.6).

2.94 It is widely acknowledged within India that this technologicalinfrastructure has not generally succeeded to meet the ambitious objectivesfor which it was set up. There are exceptions: "pockets of world-class R&D,a well developed standards institution, and a number of R&D and technicalconsulting institutions which transfer substantial technical know-how toindustry" (ibid. para. 3.7). However, the overall impact of the sums

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invested in R&D (0.91 of GDP in 1988) on industrial productivity and dynamismhas been fairly marginal, as judged by the competitiveness and TFP growth ofIndicn industry (see below). There are two broad se4ts of reasons for thisfirst, the overwhelming role of the public sector in national R&D, an effortwhich is only peripherally concerned with industrial productivity and whichtends to be isolated from manufacturing activity (1987-b). Second, privatesector R&D, which has been growing recently (21? per annum in nominal termsin the decade to 1986-7), is still inadequate for the needs of achievingcompetitiveness. The orientation of all enterprise-level R&D, public orprivate, is conditioned by the domestic and trade policy environmentdescribed earlier. Thus, technological efforts of firms are largely directedto material substitution and adapting to needs of local markets, and totransferring technology to local suppliers or subcontractors. They arerelatively weak in terms of quality control, cost reduction, and upgradingproducts or processes in line with technological developments worldwide.5

2.95 Tables 15 and 16 set out data on the sources of R&D expenditure inIndia and on subsectoral research intensities in manufacturing. The formershows that the share of the private sector in total R&D reached a peak of 16?in the early 1980s but had declined to 12% by 1985/6, with the major chunkgoing to central agencies (of which the largest for industry is CSIR, theCouncil for Scientific and Industrial Research). This is in sharp contrastto Korea, where the private sector accounts for over three-quarters of totalR&D, and where over 60Z of total R&D takes place in the productive sector,compared to 21% in India. Table 16 also includes some Korean data for com-parison, and confirms that its industrial research intensities are muchhigher than India's (and not too different from Japan's).

5/ For a detailed analysis of the nature and determinants of Indiantechnological see S. Lall, Learning to Industrialize, London: Macmillan,1987, which describes the findings of a Bank-sponsored project.

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Table I DIAt PUALIC AND PRIVATE RAD EMMPEDTMS(Re. mtilon)

197LI 19.IZLZA 19710. 1979180 AN9/.l 1"11g 1951.8 Imam 1SMI 19M/l 196618ZNtional total 8,742 4,06 5,208 6.885 7,608 9,407 12,060 18,811 17,216 20,66 26,678

Private sector 464 502 750 621 1,207 147 1,979 2,078 2.832 2,819 8161

State governmenta 52 29 402 48 598 716 971 1,19" 1,261 1,628 1.929

Central gevernment 5,006 8,409 4,128 5,004 8,0 7.219 9,120 10,88 14,228 16,841 21,576

Central agencies 2,482 n a. 8,195 8,848 4,864 8,472 7,872 8,821 11,495 18,848 17,57of ehich:

CSIR 413 n,a. 289 26 406 481 877 900 967 900 1.10400E 42 n.e. 51 78 84 78 481 8 41 48 8

Public sectorenterprises 318 875 652 784 664 1,076 1,224 1.617 1,712 1,96 2,871

Research Assistants 89 45 6 64 8 94 114 130 148 168 260Industrial RAD 628 990 1,874 1,724 2,129 2,416 8,015 8,600 8,64 4,482 8,542

P -vatctorTotal RAD 18 14 14 14 16 16 16 15 18 12 12IndustrialTotal R&D 14 22 28 26 27 26 26 28 25 22 21 21

il Includes private and public enterprises and research eaociatons.

Source: 1989-a, p. W6.

Table 16: INDIA: RESEARCH INTENSITIES OF MAJOR INDUSTRIAL SUBSECTORS

Korea Japan1980-82 1984-87 1985 1985

1. Drugs and pharmaceuticals 1.72-2.05 1.80-2.2 (1) n.a. n.a.2. Industrial machinery 1.03-1.19 0.95-0.99(4) 3.06 2.743. Transportation 0.87-1.17 0.52-0.64(5) 2.2 2.904. Chemicals 0.87-1.00 0.78-1.45(2) 0.96 3.795. Electricals and electronics 0.72-0.84 0.92-1.11(3) 4.12 5.106. Cement and gypsum 0.61-0.76 0.34-0.45(6) n.a. n.a.7. Agricultural machinery 0.48-0.71 0.22-0.41(7) n.a. n.a.8. Rubber goods 0.44-0.66 0.31-0.32(8) n.a. n.a.9. Metallurgical industries 0.44-0.53 0.58-0.67(5) 1.14 1.59

10. Soaps and cosmetics 0.16-0.51 n.a.

La Defined as the ratio of R&D expenditures to total sales.b Ranking in 1984-87.

SourLe: 1989-e, p. 57.

2.96 A major study of Indian technology development by the Bank (1987-b)traced the inadequacies of its past efforts directly to the policy regimerather than to technology support. "As a result of barriers to firm growth,Indian producers are generally too small to mount substantial innovative

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activities; many cannot even undertake incremental technological activitiesand quality assurance work. At the same time, because of limited competitivepressure, large firms have not been encouraged to introduce cost-reducinginnovations, improve product quality and performance, or develop newproducts. In an environment characterized by limited competition, firms wereable to attain high rates of return with only marginal technologicalefforts.0 (1987-b, para. 2.02).

2.97 It was not just the trade and industrial policy environment thatinhibited technological development in India. Imports of technology in allforms were also tightly regulated, a logical counterpart to the strategy ofself-reliance and a part of the general concern in India to conserve foreignexchange. The regulations were launched in the 1960s, tightened over the1970s and relaxed in the 1980s. They applied to all forms of technology:embodied in capital goods and packaged in the form of direct investment(considered earlier), and disembodied in the form of licensing or hiringforeign consultants. The final result has been that India has, until the1980s, had probably the lowest relative reliance on foreign technology of anyof the market NICs (1987-b, p. 53); however, some relaxation in the 1980s hasled to a spurt in technology imports (Table 17).

Table 17: TECHNOLOGY PAYMENTS(Rs. million)

TotalProfits Dividends Royalties Know-how Interest Payments

1970 131.20 434.30 52.30 206.30 128.001971 99.40 388.70 58.60 121.30 807.001972 155.40 390.80 73.30 113.30 156.00 888.801973 219.10 375.10 62.10 140.80 162.70 959.801974 71.90 184.60 84.60 125.60 367.00 838.701975 203.60 248.40 104.90 236.60 256.60 1,060.001976 193.90 454.70 158.80 378.00 251.10 1,466.501977 101.30 680.10 195.00 281.40 227.00 1,484.801978 102.40 543.50 126.50 555.20 314.40 1,642.001979 143.70 509.20 93.30 439.70 252.20 1,440.101980 121.00 559.20 88.80 1,049.30 232.20 2,041.511981 121.60 589.20 159.90 2,707.00 410.00 3,988.501982 191.20 703.10 397.20 2,505.80 802.30 4,679.601933 200.00 621.10 276.00 3,148.90 815.10 5,061.101984 166.80 745.80 284.90 3,006.00 1,239.10 5,442.601985 118.00 752.00 235.00 2,679.00 2,187.00 6,971.001986 106.00 855.00 401.00 3,584.00 3,189.00 8,135.00

Source: 1989-e, p. 60.

2.98 The hiring of foreign engineering firms to provide turnkey projectsand consultancy services has only been allowed on a subcontracting basissince 1967 (prior to this foreign consultants could be prime contractors).

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Licensing was also controlled by stringent screening, administered by alengthy and cumbersome bureaucratic process. The government reduced the lifeof nearly all new licenses to 5 years, with renewal made very difficult,regardless of the period needed to absorb complex, fast moving technologies.It also placed limits on royalty rates payable for licensed technologies of3-52 (on which a 40Z tax, reduced to 30Z in 1986, was imposed), with a fewexceptions made for very advanced technologies or highly export-orientedactivities. Contractual restrictions in technology contracts (e.g. importtying, use of foreign brands, export restrictions, bans on sublicensingwithin India) were banned or sharply reduced.

2.99 These regulations do seem to have reduced technology payments byIndia over the 1960's and 1970's both by cutting the number of contracts andby reducing the rates agreed. As Table 17 shows, royalty and know-how pay-ments were generally below (often well below) $100 million per annum, verylow in relation to the size and complexity of the industrial sector. Thepartial relaxation of regulations from the late '70s led to a rapid rise,reflecting the repressed demand that existed even from the protected indus-trial sector: by 1986, royalty and know-how payments had reached about $310million. The restrictions had led to savings, but at a cost to the indus-trial sector. The technology transferred was lincompletes (all the relevantknow-how and training was not usually transferred, to save expense.); it wasoften not the latest, most valuable vintage of technology; and the durationof contracts was sometimes insufficient to ensure assimilation.

2.100 The shallowness of the technology transfer process was reinforced bythe domestic environment, which encouraged Indian firms *to pursue aminimalist as opposed to an active and more coherent approach to technologyacquisition... Until recently, most technology imports have therefore been oflimited scope, contracted for with the basic purpose of setting up manufac-turing facilities and training Indian technicians in their operation andmaintenance. They have usually been part of short-term agreements that tendto cover limited aspects of ?now-how transfer, and are often not renewed...overall, the combination of administrative rules governing the import oftechnology, the financial and other resource constraints faced by small andmedium firms, and a lack of market incentives have led many Indian importersof technology to opt for less complete but inexpensive technologicalpackages, contributing to the growing technological lag between Indianindustry and that of industrialized countries" (1987-b, paras. 3.18-3.19).

2.161 Finally, it seems the technological infrastructure set up over thedecades of heavy investment in public R&D was not able to adequately meet theneeds of Indian industry. The paucity of linkages between public sector R&Dand productive enterprises has already been noted. Links between industryand university were similarly limited. There were few effective institutionsfor enforcing quality upgrading or undertaking product design (one exceptionis the textile industry, where the industry associations set up and operatedeffective design and technology centers). A lack of coordination in tech-nology imports led to a variety of different systems being introduced, andstandardization efforts have not been able to cope with the resulting prob-lems. Technological diffusion and extension services have been poorlystaffed and operated. On the more positive side, however, a considerableinfrastructure of commercial consultancy services has developed, sheltered by

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Government protection. Much of this is internationally competitive (at leastin more routine technical, engineering and process design work) and providesa valuable mechanism for certain kinds of technology diffusion anddevelopment.

G. Education and Training

2.102 To illustrate the availability of skills of different kinds formodern industry, some indicators of human capital in India in comparison withKorea, taken from UNESCO's 1988, Statistical Yearbook, and WDR 1988 are shownin Table 18.

Table 18: INDICATORS OF HUMAN CAPITAL IN INDIA AND KOREA

India Korea

Primary Enrollments (1985) 92 96Secondary Enrollments (1985) 35 94Tertiary Enrollments (1985) 9 32No. of Tertiary Students per 100,000Population (Year) 776 (1980) 3,606 (1987 )

% of Over 25 Age group with:No Schooling 85.2 (1980) 26.9 (1987)Primary (Incompleted) 7.2 39.4Secondary (Entry) 6.6 16.7Post-Secondary 1.1 4.0

Students in general science and engineerings2 Population 0.21 1.39Z Urban Population 0.97 2.02Students in engineering only:Z Population 0.06 0.54X Urban Population 0.27 0.78

Scientists & Engineers in R&D per millionPopulation 150 1,283Students enrolled in Vocational Training IWorking Age Population 0.07 (1981) 3.06 (1986)

Sources: WDR 1988 and UNESCO, Statistical Yearbook 1988.

2.103 These figures suggest that while India has a basic level of educa-tion and training to conduct considerable industrial activity, the stock ofskills available is small in relation to the size of the economy. Even whenenrollments (in technical subjects) are deflated by urban rather than totalpopulation, India turns out stocks of below 502 of Korea's, while its stockof vocational training enrollments and scientists and engineers in R&D is farsmaller.

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2.104 Gross enrollment figures of this sort are not an accurate indicatorof the true production of skills for industry for several reasons. Amongthese, the most important relate to completion rates of those enrolled, thequality and relevance of instruction given, post-education training given byemployers (or other institutions), and the proportion of highly qualifiedengineers who stay on in the country (and in industry). By practically allthese criteria, India is likely to score rather badly. The quality ofeducation has deteriorated markedly over time in all but a few elite estab-lishments. The high figures for primary enrollments are misleadings "Stilloutlays remain far below the levels needed to achieve objectives such asuniversal elementary school attendance and eradication of illiteracy whichIndia has set for itself. The absolute level ($10 per capita in 1986/87) andshare of government education spending in GDP in India (3.4?) are much lessthan in many other developing countries, including Thailand, 4.22 ($34);Malaysia, 8.5% ($156); Kenya, 5.5? ($16), and Egypt, 4.2% ($32)... Low ele-mentary school attendance and high drop-out rates suggest that a "tilt* inoutlays towards the primary level would be desirable" (1989-b, paras. 5.23and 5.26). In addition, Indian firms do not seem to invest heavily in workertraining, compared to the 5-6% of turnover enforced in Korea, and substantialproportions of engineers trained in the elite Indian Institutes of Technologymigrate abroad.

2.105 These figures conflict with a widespread impression in India andabroad that the country has a large surplus of well-trained manpower. Thisimpression is based on absolute numbers of technically qualified persons, anddoes not take into account the size of the economy or the quality of thetraining received. Nor does it take into account the geographical and struc-tural distribution of technical manpowers it may well be that large urbancenters and large firms have an apparent largesse of engineers, while provin-cial areas and small firms have a very thin layer. The relatively slowgrowth of the economy and the various constraints placed on the manufacturingsector may also have led to a low absorption of the available human capital.

2.106 The net outcome appears to be that India does, at present levels oftechnology and with the present structure of industry, have a pool of surpluscheap, technically qualified manpower on which to draw. This manpower maynot always have the right quality or specialization needed for existingindustry, and it may be even more deficient if the structure and techno-logical levels were to be upgraded. If the industrial system as a whole wereto upgrade to the levels of competence and dynamism displayed by Korea, thereare likely to be severe shortages of technical personnel, especially in thesmall and medium scale enterprises scattered through the country. In otherwords, the slack that exists at present is probably illusorys it is causedby the low and uneven absorption of technical skills by the industry inexistence, due in turn to the policy and growth environment facing industryand perhaps the poor quality and inappropriate specialization of thetraining. Thus, while considerable upgrading of Indian industry can proceedwith present human resource, more fundamental and long-term restructuring andgrowth will need substantial addition to those resources.

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H. Impact on Industrial Efficiency

2.107 The effects of this complex structure of policies on the efficiencyof Indian industry have also been very complex. The broad impact on growth,export performance and productivity increase is fairly clear and broadlyaccepted by most observers. At least until the early or mid-eighties, Indianindustry grew slowly, lost market shares internationally and suffered low ornegative rates of growth in total factor productivity. Table 19 shows calcu-lations by Ahluwalia of TFP growth rates, figures that have been used widelyin Bank reports in 1987-88. The conclusion drawn has been:

"The small spread and the low rates of TFP growth forthe industrial sectors in India are evidence of the inabil-ity of material and human resources to shift away from areasof low growth and productivity. They are also the result ofconstraints on firm growth and the limited degree of compe-tition that has restricted India's ability to adjust to ashifting international technology frontier... Policy-inducedbarriers to growth and competition have reduced the incen-tive for product innovation and curtailed the introductionof new machinery and equipment. Thus, the stagnation ofindustrial productivity in India is related not only to con-straints on resource mobility, but to the presence of rela-tively few high growth areas undergoing rapid technologicalchange, to which resources could move. Equally important,these barriers to competition have discouraged producersfrom undertaking a myriad of minor technological activitiesnecessary to operate efficiently and improve factor produc-tivity over time." (1987-b, paras. 1.19-1.20.)

2.108 The low rates of TFP growth coincided with a rising capital inten-sity of industrial investment and widespread incidence of excess capacity inmanufacturing. Thus, ICORs in manufacturing rose from 2.8 in the 19508 to4.4 in the 1960s and 6.2 in the 1970s (cited in 1987-a, para. 3.110). Anumber of factors contributed to these very high ICORs (India's ICOR of 5.1for the longer period 1963-85 can be compared to 3.6 for Korea and 3.3 forTaiwan), and thus the implied inefficiency in the use of scarce investmentresourcest delays in project implementation, entry into highly complex orcapital-intensive activities, public enterprise mismanagement, regional dis-persal policies, supply and infrastructural shortages, creation of excessand/or over-fragmented capacity, inability to export, lack of managerial andtechnological capabilities in some firms or industries and price controls.The persistence of excess capacity (over half the 62 products groups surveyedin 1983-84 had utilization rates of under 802, 1986-b, para. 2.64) can betraced to similar causes, with infrastructural problems, managerial/techno-logical capability and price controls emerging as the raost immediate ones(ibid.).

2.109 These indicators of industrial performance are strongly influencedby a number of factors unrelated to the economic efficiency of the manufac-turing process itself. It is difficult to measure efficiency at this level,and the commonly used measures such as effective rates of protection (ERPs),suffer from their static nature and inability to distinguish technical

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inefficiency from inefficiency in resource allocation caused by protection.In India, the calculation of ERPs faces the additional problem that the wide-spread incidence of quantitative restrictions, internal controls on pricesand technological obsolescence make it very difficult to get accurate esti-mates of comparable world prices. Nevertheless, various World Bank studieshave calculated ERPs, and those are briefly described here.

Table 19: INDIAs TFP GROWTH RATES, 1966/67-1979/80

(1) (2) (3)Solow Measure Average TFP Growth

of TFP Ratio of UsingGrowth, Using Value Added GrossValue Added to output output /a

Food -2.4 0.10 -0.24Beverages -2.0 0.30 -0.60Tobacco -2.9 0.22 -0.64Textiles 1.2 0.25 0.30Footwear 3.7 0.21 0.78

Wood and Cork -0.8 0.24 -0.19Furniture 3.1 0.31 0.96Paper 0.4 0.29 0.12Printing 0.2 0.41 0.01Leather and Fur -2.2 0.11 -0.24

Rubber Products -3.5 0.23 -0.81Chemicals -1.5 0.24 -0.36Petroleum and Coal 2.0 0.13 0.26Non-metallic Mineral

Products -1.8 0.28 -0.50Basic metals -2.2 0.25 -0.55

Metal products -2.1 0.26 -0.55Non-electrical Machinery -0.1 0.29 -0.03Electrical Machinery 0.9 0.27 0.24Transport Equipment -0.3 0.30 -0.09Miscellaneous -1.5 0.29 -0.44

Total -0.7 0.22 -0.15

/a (3) - (1) x (2).

Source: Isher Ahluwalia, Industrial Growth in India, Stagnationsince the Mid-Sixties, Oxford University Press, New Delhi,1985.

2.110 Table 20 qummarizes the results of ERP calculations for the 59 manu-facturing sectors (3-digit level of Indian Annual Survey of Industry data)producing tradable goods in India (1987-a). It must be noted that this is ahigh level of aggregation, and some fairly heroic assumptions have to be madeto arrive at prices and costs for the diverse products covered. To partly

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compensate for this, the results are presented as broad ranges rather than

precise numbers. Nevertheless, as they stand the calculations show some

findings of interest:

Table 20: INDIA: EFFECTIVE PROTECTION OF MANUFACTURING INDUSTRIES

Effective X Share X Share 0000 Fixed Cap. Avg. Lab. CostProtection No. of Fixed Persons X Share KOH/VA (Rs.000)/ (Re. '000)/

(1986) Sectors Ca. Encaed VA (Re. 000) Pere. Eno. Pero. Eng.

High 21 58.2 18.6 39.0 409 92.5 16.8Medium 5 8.5 8.4 6.8 128 82.4 18.04Low 80 48.1 77.7 54.9 199 17.8 9.86Miscellaneous 3 0.2 0.4 0.8 79 15.7 9.76All Industriee 59 100.0 100.0 100.0 266 82.1 10.36

Note: High ERP a > 705.Medium ERP a 80-705.Low ERP = < 805.

Source: World Bank (1987-a) Table 4.6.

- The structure of ERP is clearly bimodal, with 39Z of value addedcoming from industries with high ERP and 55? from those with low ERP(including negative ERPs). The average level of protection (using

middle values of estimated ERP ranges) for Indian manufacturing is40% if world value-added is the weight used. This average would be

lower, and the proportion of value-added originating in low ERP

industries h..gher, if small scale and artisanal manufacturing had

been included in the data.

- Highly protected activities have higher wage levels and higher powerutilization as well as higher capital intensities. Most of them

congregate in complex process industries (like chemicals of variouskinds and petroleum, pulp and newsprint, iron and steel and non

ferrous metals) and skill-intensive activities (electronics,aircraft, professional equipment). The average figures for capitalintensity conceal considerable variation, however, and it is not

easy to decipher from the data presented what exactly is causing the

variations in ERPs across activities. A high proportion of outputfrom the highly protected sectors is accounted for by public sector

enterprises, and this may itself be an independent explanatoryfactor. It may be too simple to trace a direct causal connectionbetween capital-intensity and inefficiency without taking into

account such factors as ownership, skill and technologicalrequiremev.ts, infrastructure, input supply, location, realization of

scale, scope and learning economies, and institutional support.

- The overall level of protection given to Indian industry is

surprisingly low in view of its trade and industrial strategy. The

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low ERP segment contains several activities that may be expected tobe efficient in view of their simple technologies (food processing,textiles, garments, leather, plastic products, glass or metalproducts), but also some that are capital intensive (paper. cement,steel foundries, synthetic textiles), or demanding of skills andtechnology (trucks, scooters and motorcycles, non-electrical andelectrical machinery). On average, however, the capital intensityof low ERP activities is much lower than that of high ERPactivities.

2.111 Detailed studies of various industries undertaken in India by theBank provide a clearer view of the complex interactions between internal(to the enterprise), external and policy induced factors that have led tothe present state (for brief reviews of some subsector studies see 1987-b,chapter IV, and 1985). The high variability of protection persists at thedetailed product level, confirming the dangers of attributing too simple aset of explanations to the structure of efficiency in India. Moreover, theconfiguration of explanatory variables changes over time and from industryto industry. Some sectors that were competitive in earlier periods (ironand steel) are less so now; some that are efficient in a technical senseare uncompetitive in export markets because of outdated processes(textiles) product designs (trucks) or inadequate marketing (variousengineering and textile products); some that are both efficient andcompetitive are unable to export fully because of inadequate capacity(cement), raw materials (paper) or infrastructure (textile equipment); andso on. Nearly all the problems can, at one or more removes, be traced backto policy errors, both of omission and commission. The implications thatemerge for industrial strategy (see next section) are not at allstraightforward.

2.112 The capital goods industry may be used as an illustration. It wasanalyzed by the Bank on two occasions (in 1984 and 1989, see 1989-d), withthe latter report containing a detailed review of the sources of uncompeti-tiveness and a comprehensive program for upgrading. The earlier report,using cost-price data for 1980-82, found that all the product categoriesreviewed (boilers, non-electrical equipment for cement, pulp and paper,sugar and machinery for petrochemicals, fertilizers and petroleum refining)had uniformly negative effective protection; DRCs ranged from 0.3 to 0.7for cement machines, 0.3 to 0.8 for sugar machinery, 0.5 to 0.6 forpulp/paper machinery and 0.8 for boilers. The output was sold at or belowworld prices in India while input costs were significantly higher. Lowerlabor costs and fairly high rates of operational efficiency (70-801 againstinternational technical norms) allowed the sector to achieve costcompetitiveness. However, exports were relatively low (except for boilersmade by the public sector BHEL) because of the balance of incentives, poormarketing capability and some obsolescence in product design. On the otherhand, a relatively relaxed application of licensing controls had led to afair amount of competition at home, while considerable technological effortby industry leaders had led to an impressive build-up of manufacturing,adaptive and turnkey capabilities (analyzed in detail in Lall, 1987).

2.113 The 1989-b report obtained somewhat different results for itsestimates of ERPs. The sample of products and firms was different from the

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earlier study, but it was suggested that the main difference -- a higherlevel of ERPs in 1989 study -- arose from the policy shift to give greaterprotection to capital goods. The median rate of ERP for the sample of 13products (made by 8 firms) was 7.1Z, with the range from a low of -19.62 (4items had negative rates) to a high of 38.42.6 Even this rate ofprotection is fairly low, much lower than suggested by nominal tariff ratesor even collection ratess it appeared that substantial portions of thesubsector had accumulated sufficient skills and technology to reach highlevels of competence by world standards. The consideration of other ERPstudies (done within India) suggested that the bimodal pattern observed forindustry as a whole also applied to a large sample of capital goods, withsome 502 of the sample in the efficient category and 25Z in the highlyprotected category. Again, public sector firms tended to be grouped in thehighly protected category.

2.114 Despite its apparent efficiency, the industry was overwhelminglyinward-oriented, with exports at only 2-6Z of total output. The tradepolicy structure was biased against exports and held back the mostefficient firms; it also reduced pressures to keep up with moving worldtechnologies. Equipment tended to be outdated. While domestic competitionin capital goods was active, it was insufficient to ensure world-classperformance. Regulations on exit, technology import and foreign investmentheld back greater dynamism. Institutional support for training, R&D,testing, information and industrial extension was deficient. The provisionof appropriate technical and managerial skills needed considerablestrengthening. R&D into product design was inadequate. As a result, evenlow-cost producers tended to suffer from product design lags, qualityproblems, insufficient specialization and insufficient R&D into achievingworld-class design and engineering capabilities. Table 21 summarizes themain technological gaps found in capital goods.

6/ The product-wise ERPs, in ascending order of protection, arettransmission line tower -19.6; precision grinder -14.3; heat exchanger-8.2; pressure vessel, case 1 -4.0; transmission tower (exported) 3.5;pressure vessel for fertilizers 6.2; heat exchanger for fertilizers 7.1;lathe with accessories (exported) 7.3; reciprocating process pumps(exported) 7.3; pressure vessel, case 2, 8.0; lathe with accessories9.0; reciprocating process pump 22.1; and exhaust gas turbocharger 38.4(1989-d, p. 44).

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Table 21: SUMMARY OF THE MAIN TECHNOLOGICAL GAPS FACING INDIAN CAPITAL GOOD

Technological Level (Gap)Industrial

Sub ect India Countries

1. Average age of facilitiesand equipment >20 years: 182 5-10%

<10 years: 542 60-802

2. Capital intensity 2/3-1/10 1

3. Export Performance 2.61-7.0 10-20%

4. Design and Engineering 1/5-1/2 1(Human resource allocation)

5. Technology Acquisition Controlled Less restrictedTechnology Licenses 0.08? 0.22 Korea(Imports as X of GNP, 1979) 0.32 Mexico

6. Specialization <10Z 40-602(a) Subcontracting

7. Process Technology(a) Defect rate 3.52 0.252-1.0X(b) Precision level moderate extremely precise

8. Production and processcontrol systems(a) Labor loading man-days: 47Z near 02(b) Machine loading machine-days: 36? near 02

9. Institutional support weak strong

Source: 1989-d, p. 87.

2.115 This case study shows both the positive and negative aspects of theIndian strategy. On the positive side, a considerable capability has beenaccumulated in the manufacture of a range of complex, skill-intensive goods.On the negative side, this capability has not embraced all the aspects neededfor dynamic competitiveness; existing capabilities have not been fullyexploited in terms of growth of exports; technological gaps have grown andinefficient enterprises, especially in the public sector, have remained con-tinuing burdens. The beneficial effects of policy have been liberally inter-laced with the negative effects of the complex, cumbersome and often wrongly-directed trade and industrial regime. As with other industries, a few goodfirms have emerged (though they are unable to become world-class competitorsin the Korean mould), but have co-existed with large numbers of lessefficient laggards. Thus, while the good firms are substantial exporters of

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technology (in various forms) to other developing countries, 7 making Indiaone of the leaders among the NICs in the sale of its know-how, thiscapability has not grown or diffused sufficiently, in extent as well asdirection, to enable the industrial sector as a whole to be as successful asthat of other NICs.

2.116 The recent spurt in output and exports, and presumably also in TFP,testifies to the unexploited capabilities that exist in Indian industry.These capabilities are evidently spread across a broad spectrum of activi-ties, and a significant portion can probably be galvanized into internationalcompetitiveness fairly quickly with modest injections of technology, equip-ment, skills and appropriate changes to incentives and regulations. A largeportion will clearly need more substantial infusions and longer adjustmentperiods and a large number of "sick" firms may have to be closed downaltogether. Improvements in education, training, technology andinstitutional support will have to be integral to these changes and raisequite separate policy issues (i.e. unrelated to trade incentives andindustrial regulations).

I. Assessing the Role of Interventions

Introduction

2.117 This section deals with some broader questions of industrialstrategy that are central to policy analysis of the type undertaken by theBank. India is widely regarded as the prime example of relativelyunsuccessful and costly industrialization (or, at least, of unrealizedpotential) because of policy errors: excessive inward-orientation andinternal regulation of competition in product and factor markets, biases inownership and location and inadequate provision of infrastructure, bothphysical and technological. The traditional focus has been on its import-substituting trade regime, which has been associated with selectiveinterventions. Of the selective interventions, high and variable levels ofprotection granted for indefinite periods have been taken as the maiaculprit. The Indian case is thus the main example of the harm caused byselective intervention and of the benefits to be gained from greater relianceon market forces.

2.118 There is little doubt that much of the blame for India's lack ofindustrial "success" rests with policy errors. The real questions arewhether its policy has really been that of selective intervention, whetherthe interventions have been properly implemented and whether the remedies liein non-interventions or selective interventions of a completely differentkind. While these questions cannot be investigated at length in this study,the answers are directly relevant to an understanding of industrialdevelopment and the Bank's approach to industrial strategy. For this reasona slight digression on the relevant concepts is justified at this juncture.

7/ See S. Lall, "India", in special issue of World Development, May-June1984 on "Exports of Technology by Newly Industrializing Countries".

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2.119 Not all interventions with market forces that have a selectiveimpact are necessarily "selective interventions" in the economic sense. Aneconomically 'selective intervention" is one intended to promote a chosenactivity over others because of perceived or anticipated market failuresassociated with that activ.i,y. 8 Economic selectivity differs from otherforms of selectivity in that it is specifically directed at remedying marketfailures that impede the chosen activity's progress towards efficiency.Depending on the scope and origin of the market failure, economicallyselective intervention can encompass protection, subsidization, taxation,institutional development or other forms of promotional support (educationand training, technology creation or diffusion, developing a supplier andservice network -- all geared to the activity selected).

Nature of Indian Interventions

2.120 In the Indian case, an important distinction has to be drawn betweeninterventions with selective effects and interventions designed to beeconomically selective. It is evident that the Indian strategy was, by andlarge, of the former, and not the latter type: it was in large part a non-selective strategy, often dominated by non-economic objectives, not directedat overcoming specific market failures, and with little attempt at building-in safeguards against the anti-competition biases of intervention. Thewholesale, indiscriminate and permanent nature of import substitution meantthat potential competitiveness was not the basis of whatever selectivity wasexercised. The imposition of various controls on location, growth,competition, prices, diversification, exit, technology imports, and so onreveal the heavy overlay of non-economic objectives and the lack of attentionto the needs of each activity to achieve competitiveness. The ethos was notto restore the efficient functioning of markets but to control the effects ofmarket forces. This meant that only a few competitive spurs were left toinduce productivity growth by enterprises. As far as the remedying of'internLl' market failures are concerned, therefore, Indian policy was notdesigned to be economically selective.

2.121 The same applies to the remedying of market failures external toindividual enterprises. While India created a large base of technicalskills, its extent, specialization and quality left much to be desired. Thetechnological infrastructure provided insufficient specific or genericsupport to industry. Supplier networks 'eveloped under duress -- the forcedpace of import substitution -- but did not, in many cases, promote efficiencyor specialization. Other forms of institutional bupport were not very effec-tive, while physical infrastructure constituted an increasing bottleneck toindustrial growth. The constriction of technology inflows along with therestriction of direct investment deprived Indian enterprises of valuableI puts to their capability development process.

2.122 The "failure" of the Indian strategy thus reflects the failures ofits non-specific and poorly implemented approach. It does not as such affectthe case for selective interventLons. On the contrary, since the Indian

8/ For a succinct analysis see Vol. 2 of the Bank's 1987 report, Korea:Managing the Industrial Transition and the related discussion of the Koreacase in this study.

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strategy had some of the protective elements of selective policies, the bene-ficial effects expected of specific interventions may also be found under thenon-selective strategy pursued. While prevented from reaching full develop-ment and overburdened by the non-economic factors noted, these beneficialeffects are reflected in the diverse range of competitive abilities evidentin Indian industry. The effects derive from protection-assisted learning ofcomplex technologies and the development (however inadequate) of supportsystems and technical skills. In some industries, like capital goods, arelaxation of constraints on domestic competition greatly helped the processof maturation and led to considerable gains in productivity and efficiency.In others, like a range of heavy process industries, competitive techno-logical capabilities were built up behind high protection where scale, rawmaterials, infrastructure and managerial autonomy permitted. In simplerindustries, competitiveness had existed for considerable periods despiteprotection and inward-orientation.

2.123 To conclude this section, the performance of the Indian system ofinterventions should not be confused with that of a system of coherent,economically oriented selective interventions. The Indian strategy was notdesigned to intervene selectively to promote industrial efficiency, and someelements of its strategy that were aimed at promoting capability acquisition(education, R&D, selection of technology imports) were not well implemented.Ideology, non-economic concerns, a neglect of economic realities and thepursuit of conflicting objectives prevented the government from adopting atruly selective strategy. Nevertheless, some elements of selective interven-tion existed. These all-wed Indian industry to diversify and deepen itsstructure and to master, albeit imperfectly and without sufficient dynamism,a broad range of complex technologies. However, the fact that protection wasoverextended, exporting rendered unattractive, domestic competition andgrowth restrained, local content raised regardless of cost and quality, andtechnology and infrastructure inadequately provided, took a severe tool ofthe development and in the exploitation of these capabilities. Ultimately,the effects of the non-economic interventions were seen clearly in theuncompetitiveness of Indian industry. The most pressing need for policyreform in India, therefore, remains in the area of incentives andderegulation.

2.124 The accelerated growth of the industrial sector since 1985 isclearly attributaole to the cumulative effects of gradual deregulation oflicensing, more intense domestic competition and some trade liberalization.The significant changes have been in the regulations concerning domesticinvestment, production, exit, marketing and taxation of industry. Thesepolicy changes have, all in all, reduced regulatory or administrationbarriers to enable more efficient allocation of resources, though much of thedirect control mechanisms for resource allocation remain intact. In thefinancial sector, not much has been achieved, but the active exchange ratepolicy has helped the export sector. In fact, the export promotion policyconstitutes the main thrust of recent changes in India's trade regime. Notonly have the imports of cummodities. parts and components for eventualexport been made more liberal and streamlined, the export promotion schemeshave also remained under constant scrutiny in order to improve theireffectiveness.

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III. THE BANK'S ANALYSIS OF INDIAN INDUSTRIALIZATION

A. Introduction

3.01 The World Sank has probably invested more resources in analysis ofand policy work on industry in India than in any other member country. Overthe years, a large number of detailed sector and subsectors studies, based ontechnical and economic analysis, have been prepared, with the coverage risingsharply in the mid-1980s. This latter period has also seen the preparationof a number of policy documents, on the regulatory aystem, technology devel-opment, export policies, sick industries, public sector enterprises and soon.

3.02 The Indian Government has welcomed and appreciated most of the de-tailed subsector studies, for their technical excellence, their cross-countryperspective and useful policy recommendations. Some of the policy studieshave also been welcomed, like the one on export policy, which in the Govern-ment's view provided sensible, useful and practical advice, much of it imple-mented. Others have been regarded with less warmth: the prescriptions werefelt to be too general, too ideological or simply impractical in the Indiansituation. However, over time the government itself has moved much closer tothe Bank's market-oriented philosophy as the inefficiencies of its own strat-egy have become obvious. Nevertheless, significant differences remain on thedetails of policy changes thought necessary, on the spread of reforms and ontheir sequencing. In particular, the Indian government has felt uncomfortablewith what it regards as the Bank's ideological bias in favor of foreigndirect investment, private ownership, non-selective interventions and a fastpace of sweeping liberalization. It also noted inconsistencies between thissort of "line" in CEMs and general policy dialogue and the more pragmatic andgradual approach adopted in subsector studies.

3.03 Many of these disagreements do not reflect on the quality and objec-tivity of the Bank's work; some others show that real questions of substanceremain on the Bank's approach to industrial strategy. What is generally ac-cepted is that the Bank's subsector reports on India are excellent, and prob-ably among the best industry work done within the Bank on any country. Theyhave been useful to Indian policy makers and also, on occasion, to Indianindustry (as with the automobile sector study). The broader studies of strat-egy or policy have fed into the Indian government's thinking and policy dis-cussions, but their impact has generally been less evident (with notableexceptions, like the export development study). Nevertheless, they have pro-vided inputs and stimulants to government thinking, with probable long-term(and unacknowledged) effects that reinforced policy changes that w'.re comingunder pressure of various other forces.

B. Assessing Structural Change

3.04 As with the other country studies, the early reports of the Bank onindustry in India favored an import-substitution based drive into heavy in-dustry as the best way to speed up the process of structural transforation.Serious reservations were expressed by the Bank of the Indian bias towardspublic ownership, the physical planning approach that neglected properproject evaluation, the disregard of comparative advantage and the excessive

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protection given to industry, but the basic strategy of selective interven-tion to promote entry into complex producer goods was not in question. Toquote from the famous Bell Report (1965), Volume I, at some length:

"We have already indicated that we do not take issue withthe basic strategy of the Government of India in devotinggreat resources to the development of industry, andparticularly industry to produce some of the basicintermediate materials such as steel, chemicals, fuels, anda range of equipment and machinery. A variety of attempts,some highly sophisticated, some less so, have been made todemonstrate faults in this strategy. In essence these appearto argue that the allocation of a larger proportion ofinvestment to less capital-intensive purposes and toexpanding both the current output of consumer goods and thecapacity to produce such goods, would result in a more rapidincrease in aggregate output and income and correspondinglyin both consumption and savings. These arguments do notappear to us to take adequately into account the import-export gap or the difficulty of translating enough of theprojected output into export. We find the attempteddemonstrations unconvincing. We regard as mistaken, however,some of the ideas which have been associated with the basicdevelopment strategy of the Government and which influencethe manner in which it is being executed. We refer here tothe tendency to make particular industrial investmentchoices without adequate consideration of the comparativeand distinctive economic costs and returns involved. Werefer also to the related somewhat unselective effort toestablish import-substituting production at any cost and theneglect of the possibility that export production andinternational trade may be a more advantageous means ofmeeting some requirements. Associated with this is theattempt, through the import control system, to provideabsolute protection to any and all types of import-substituting production, regardless of the cost of suchproduction. We refer also to what appears to beinsufficient concern with efficiency and inadequate effortto establish conditions under which there are pressurastoward and premia on efficiency in production, whatever thecharacter of the production activity" (para. 76).

3.05 This argument specifically rejects any attempt to determine India'sappropriate industriai structure on the basis of simple factor-endowmentcriteria. Its case for rapid deepening rests on balance-of-payments consid-erations (on very similar lines to the Indian planners' export-pessimism).In a country of India's size there iR little doubt that a fairly diverse andself-sufficient industrial structure has to be set up: the real questionsare about the pace, selectivity and efficiency of the effort. Given the sizeof the (existing and potential) markets, which can sustain much of modernindustry efficiently, this translates into issues of the availability oftechnological and managerial capabilities, the speed of acquiring these capa-bilities and the developmen of supporting human, physical and institutional

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structures. 10 The lack of selectivity and the wrong incentives embodied inthe Indian strategy were clearly recognized in these early reports.

3.06 The 1970 report on trends in Indian manufacturing industry put thesearguments even more clearly and persuasively. Tracing the historical back-ground to the government's inward-looking strategy (self reliance as an ob-jective and, later, export pessimism), it noted that "there is nothing wrongwith the Import Substitution (IS) strategy in itself" (para. 21). India couldmake IS work better than any developing country, and protection was a charac-teristic feature of all early industrializers except for Britain. But themain weakness of the Indian strategy was its neglect of efficiency and un-selective approach, which meant that "Cost minimization, innovation and prod-uct adaptation all receive lower priority than the achievement of specifiedphysical output goals" (para. 22). Even in ranking of products to be manu-factured, priority did not seem to have been given in terms of a rate ofreturn, or of potential for productivity gain, or some other economic crite-rion (para. 27). The vagueness of policy goals and conflicts between specif-ic objectives distorted economic activity, and pervasive controls "did notproduce a concern for the productivity growth on which long-run growth de-pends" (para. 40).

10/ These issues were brought out and discussed, for example, in a reportentitled "Certain Aspects of the India Steel Indastry," No. AS-111a,1966, in which the delay in construction and the low capacity utilizationof the three now public sector steel plants at Bhilai, Durgapur andRourkela were traced to many factors, but most importantly, to thepaucity of experienced technical manpower. Despite the initiation ofvery large and elaborate training programs (e.g., overseas training for1,600 engineers and over 500 operatives) at the beginning of the SecondPlan -- and a heavy draw on the human resources of the existing privatesector firms namely Tata Iron and Steel Corporation and Indian Iron andSteel Corporation (well over one-third of the senior production personnelat Hindustan Steel Ltd. were veterans of the two private sectorcompanies), the depth of experience required for the efficient operationof the steel plants (the 8-10 years' practice it takes to make a good"steel man") could not be acquired in such a short period of time. Inaddition to the shortage of qualified managerial personnel, HindustanSteel Ltd. was run by a Board of Directors -- many transferred from highcivil service pisitions -- who appropriated too much responsibility tothemselves for the plant's maaagement and day-to-day operations. Theseproblems were compounded L; the little delegation of authority, inappropriate salary scale and euployment shortcomings. The result wasthat an industry whose costs of producing steel in 1955 was amongst thelowest in the world was no longer as competitive in 1965.

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3.07 The achievements of the Indian economy in changing the structure ofmanufacturing were commented on by nearly all Bank reports. The increasingself-reliance of industry, with its counterpart in growing internal indus-trial linkages, were noted favorably -- but always with major qualificationson efficiency and productivity growth. The 1970 report noted that IS mayhave "exhausted itself as a source of growth" (para. 105) and relaxation ofimport controls could lead to improvements in efficiency. Self reliance hadbeen confined to substituting for imports but had not encompassed growth inmanufactured exports: output growth without regard to comparative advantagehad taken its toll on efficiency and productivity.

3.08 Over the 1970s the issue of structural change dropped out of sightin Bank reports as industrial stagnation in India concentrated minds on effi-ciency, technology and export competitiveness, and as the Bank itself movedfrom structural questions to those of reform of incentive systems. By thetime the comprehensive industrial policy review of 1987-a appeared, struc-tural transformation was given a perfunctory acknowledgement: "India's tradeand industrial regulatory policies have had a pervasive role in shaping thedevelopment of the sector since Independence. They have produced a diverseindustrial structure and reduced imports" (para. 3.04). And later: "Thegoals of heavy industrialization and import substitution appear to have beenachieved. Basic and capital goods production have risen relative to interme-diate and non-durable consumer goods.... However, this was achieved at somecost in terms of growing capital intensity and slow growth of employment...."(para. 1.69).

3.09 The 1987-a report spent much more time under the heading of"Industrial Structure", on the distortions in the size distribution of firms(the "miising middle"), fragmentation of plants, concentration levels, inap-propriate product specialization and location than on evaluating structuralchange in the Chenery tense.1 1 Later reports related to industry similarlyignored this issue. Thi implicit reasoning appeared to be that India hadachieved (indeed, over-achieved) its early aims, but at huge cost, and thatthe important policy questions really concerned the reduction of this cost.The wholesale import-substitution policy pursued by India did indeed seem tohave taken its industry into practically all available product areas.

C. The Slowdown in Industrial Growth During the 1970s

3.10 The early and mid-1970 CEMs were woeful tales of very low industrialgrowth and low capacity utilization in most industrial sectors notably ironand steel, fertilizers, textiles and engineering goods arising out of a num-ber of factors such as the paucity of foreign exchange, the shortage and lowquality of raw materials, sluggish demand, labor problems, unsatisfactorymaintenance of plants and generally inefficient management. A serious secu-lar decline was being detected in the productivity and profitability of manyimportant large and medium scale industrial plants as capital output ratiosof most industries continued to rise while value added per rupee of laborcost declined. Many public sector enterprises, especially steel and capitalgoods producers were suffering from low profitability. In general, thesereports traced the slowdown of industrial growth to the economic policiespursued by the Government. The 1973 CEM statedt "the very success achieved

11/ H.B. Chenery...

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in import substitution has reduced the scope for changing rapid industrialgrowth by concentrating on producing primarily for the domestic market. Inaddition, the increasing preoccupation with restricting the larger industrialhouses has undoubtedly dampened their investments despite the greateravailability of resources and know-how in this sector, without touching offan offsetting investment spree by the rest of private industry including thesmall-scale sector for which 128 fields of activity are exclusively reserved.Finally, the production record of public sector has not always been commen-surate with the volume of resources absorbed by it' (para. 6.07).

3.11 The 1977 CEM sought to explain the secular slowdown in growth in thelate 1960s and early 1970s. In essence the explanations revolved round theslow growth of aggregate demand, and distortionary trade and industrial poli-cies, which had created gross inefficiencies and severe imbalances betweendomestic demand and capacities created for home markets. The pervasive con-trols had led to widespread industrial obsolescence, and private investmenthad dropped in response to sluggish demand and policy uncertainties.

3.12 A dynamic export activity could have possibly resolved the problem,but the Indian industry was in no way export-oriented. The 1971 study onIndia's Export Prospects Traced India's export performance since the begin-ning of the First Plan and noted how, despite a healthy diversification ofexports, India's share of total world exports had declined from 2.411 in 1948to 1.09? in 1961 and 0.73% in 1968. It argued that since the contribution ofprimary and quasi-primary products to exports would likely remain marginal,the bulk of India's exports would have to come from industrial goods. Itconcluded that if India took the necessary measures in order to improve theproductivity of its industrial sector (e.g., some import liberalization) andreformed its export administration and procedures, there was a reasonablepossibility that its exports of manufactured goods such s iron and steel,chemicals, engineering and consumer/semi-durables would increase at a muchhigher rate than the traditional exports.

3.13 A second study entitled 'India: Export Performance, Problems,Policies and Prospects" (1977) concluded that India needed to reform itstrade policy in order to create a degree of specialization in the Indianeconomy. It further needed to pursue the path of comparative advantage.While export targets in the range of annua3ly 8-10Z volume growth should beachievable, incentives needed to remain stable, uniform and efficient andexporters should be permitted access to imports for competitiveness. The1979 CEM noted that vYery little industrial capacity had been set up with aspecific orientation for exports.

3.14 The 1984 CEM noted the underutilization of scarce resources due to Malong delays in project implementation' and *poor utilization of existingcapacity.' Among the factors leading to underutilization of capacity, itmentioned specifically poor maintenance of plant and equipment; inadequatecurrent expenditure to improve technical staff management and training; in-sufficient investment in rehabilitation/modernization plants; insufficienttransfer of technology; and shortage and/or poor quality of key inputs.12 Bytaking the example of cement industry where a policy reform involving limited

121 Exactly the problems enumerated in the Bell Report 20 years earlier.

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price decontrol, partial removal of implicit freight subsidy and importliberalization had led to substantial investment in new capacity, improvedefficiency, more efficient location of new capacity and the elimination ofblack market sales, the report discussed the many ways of eliminating under-utilization of capacity. It concluded by reiterating the need for the crea-tion of a generally more competitive environment for Indian industry in boththe public and private sectors.

D. Understanding Indian Industrial Performance

3.15 The assessment of Indian industrialization has taken many forms overthe years. The findings of the ERP calculations have already been discussedearlier. In addition, selected product groups have been analyzed, sometimesin considerable detail, with respect to cost competitiveness as well as qual-ity, obsolescence, scale and diversity of output, technological charac-teristics, marketing and after-sales service and even the efficiency of vari-ous processes in the production cycle. The volume and quality of these sub-sector studies are, as noted earlier, impressive. While individual reportsvary in coverage, emphasis and depth, in general they are objective and well-informed.

3.16 This accumulation of detailed industrial studies provided the Bankwith an in-depth knowledge of industry in India that few, if any, countriescan match. While few of these studies have led directly to Bank operationsin India, they have furnished the basis for a dialogue with the governmentwhen more general policy discussions were stagnant. Over time, the generali-zations emerging from the micro-level assessments fed into and strengthenedthe Bank's arguments for more general reforms in trade and industrial poli-cies. While some questions remain (considered below) about the inter-pretation and implications drawn from the subsector studies by the Bank, asan exercise in the assessment of industrial development at the ground level,the Bank's work on India deserves unsullied praise.

3.17 What has just been noted for the assessment of Indian industriali-zation at the microlevel also applies, by and large, to the Bank's analysisof the firm-level determinants of performance. The subsector studies oftenwent into great detail on the incentive, technological, ownership, insti-tutional, skill, infrastructural, scale and supply-support factors whichaffected particular activities or firms. They noted successes and strengths

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as well as failures and weaknesses.13 The Bank's analysis of India was muchfuller on these points than of Korea or Indonesia. Moreover, the quality ofthe subsector analysis was high from the early days (when a number of indus-try studies were undertaken in conjunction with the industrial import creditsin the 1970s). The later studies, especially around the mid to late 1980s,were richer in that they went into relevant policy issues, and often broughtto bear international comparisons which were particularly illuminating.Clearly, the "failures" of Indian strategy and the recalcitrance of thepolicy makers stimulated the best in the Bank's efforts.

3.18 There were inevitably some differences between individual studies interms of emphasis and coverage. A general deficiency was the inadequatetreatment of skills: while skill gaps were sometimes mentioned, there waslittle attempt to pinpoint the precise nature of the gaps, and whether theproblem lay in the education/training system (external to the firm), in theinternal system of training and incentives, or in the general labor environ-ment. In practice, skill gaps are very difficult to identify with any preci-sion. However, the role of in-firm training is extremely important inachieving and maintaining competitiveness, and the significance of this inthe better Indian firms, though noted (as with TELCO, Bajaj, HMT and thetextile equipment firms), was not fully brought out. The skill deficienciesof smaller firms were not explored.

3.19 The Bank's analysis of production capabilities was not matched bythat of the two other major forms of technological capability: investmentand linkage. Investment capabilities refer to the ability to appraise, de-sign, select and/or manufacture equipment for, erect and commission an indus-trial project. The early industry sector reports made much of poor projectselection and long delays in implementation, but the focus was on the use ofnon-economic criteria and delays caused by bureaucratic (or political) imped-iments or the insistence on local procurement. This tended to neglict the

13/ The 1980 Cement Subsector Study was a waterhsed report in the Bank'sapproach to the industrial policy dialogue with India. In the preface tothis report it is noted that the study is the first in a series designedto: "(a) improve the Bank's understanding of the industrial sector inIndia; (b) serve as a foundation for a policy dialogue with IndianGovernment on issues facing the sector; and (c) contribute to the designof an effective lending program in the industrial sector." The reportcontained a series of technical and economic recommendations coveringissues related to raw materials, packaging, quality, energy,transportation, technology, research and development, retention pricesand export potential.

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technical aspects of investment capabilities: whether or not Indian firmsand consultants could design and engineer projects efficiently, whether theycould arrange for appropriate technology transfer and equipment and whetherconstruction and erection skills were developed. Later studies dwelt onpolicy induced constraints like fragmentation of capacity, rigidities intechnology and equipment import regulations, lags in local equipment designand (again) bureaucratic holdups.

3.20 While these concerns may have been relevant for pressing policyreform, they tended to overlook the very real achievements of Indian industryin building up a complex and difficult set of investment capabilities in avariety of process industries. One of the worst performing sectors, iron andsteel, possessed some of the most advanced sets of engineering capabilitiesin the developing world, with firms like Dastur and, to a lesser extent, thepublic sector MECON, selling their consultancy services internationally.Similarly, the petroleum refining and petrochemical sectors had areas oftechnical excellence in process design and engineering. The lessons of theseachievements were that, first, they were reached by deliberately protectinglocal engineering capabilities and, second, were the result of assiduousefforts in acquiring skills and knowledge by the firms concerned. Bothlessons are significant for the Bank and other developing countries, forobvious reasons. Yet recent reports (as on technology development, 1987-b)have dwelt at length on the inefficiencies of government intervention withtechnology imports and the inadequacies of local technological development:mostly correctly, but at the risk of drawing the wrong lessons for capabilitydevelopment.

3.21 Linkage capabilities refer to the skills required to set up suppliernetworks and exchange technical and other information with component suppli-ers, subcontractors, R&D institutes, consultants and other relevant enter-prises. In developing countries, in general, linkage capabilities requiresubstantial investment and effort to acquire. In highly import-substitutingcountries like India, they are even more expensive because of the pressuresto build up local supplies very rapidly, and can, unless well implemented,lead to many inefficiencies.

3.22 Bank reports have tended to underplay the development of linkagecapabilities in India, using ccmparisons with advanced industrial countriesto suggest that Indian firms are exceptionally vertically integrated. Whileit may be the case that the extent of specialization is lower in India, it isalso the case that in a variety of industries, especially engineering, Indianfirms have achieved extensive "ancillarization". This has involved them inconsiderable design, skill transfer, technical assistance and general *nurse-maiding" effort (Lall, 1980, on truck manufacturers in India). Some of thiseffort may have led to inefficiencies, but some has certainly led to thedevelopment of efficient, flourishing subcontracting networks that should beable to provide a strong base for international competitiveness in a moreoutward-looking regime. More significantly, Indian industry is building up adense network of information and technology flows, with the growth of a host

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of specialized intermediaries, that marks the advent of industrial maturity.While the policy regime had, as noted above, extensive costs in other ways,some of its positive aspects should not be neglected.

3.23 Apart from these oversights, the subsector studies maintained a goodbalance between incentive, capability and institutional factors affecting theperformance of particular activities. As with the Korean case, however,there was little attempt to understand the process by which existing capabil-ities had been acquired, and thus the reasons why some firms in most indus-tries had achieved international levels of cost competitiveness while othershad not. 14 Emphasis was laid on the policy-induced barriers that led totechnological lags (especially in product design) even in the "good' firms,and to fragmentation and constraints on competition that allowed the laggardsto survive. This may have been appropriate for the immediate purpose of thestudies (guiding policy reform), but was not geared to drawing lessons at theactivity level on what made for efficient wlearning". Nevertheless, in com-parison to industry work on Korea, the studies on India had much more detailon current practice from which some inferences could be drawn about pastdynamics.

3.24 The emphasis on incentives (and so regulations) increased when sub-sector reports were drawn upon to prepare studies on broad issues such astechnology development (1987-b) or regulatory policy (1986-b). The absenceof a comprehensive analytical framework within which to place the inter-actions of incentive, protection, skill development, technological effort andinstitutional development, noted in the Korean study, became more evident atthis level. This took the form of a simple incentive-based approach, whichwas helpful in getting across more forcefully the message on desirable policyreforms, but did not necessarily make for a full understanding of the indus-trialization process or of the proper role of government policy. The generalanalysis had a great deal of validity: as described earlier, misguided in-terventions did immense harm to Indian industrial development. However, thepredominant emphasis placed on competition, internal and foreign, as the soledriving force of healthy industrial development, seemed to assume that mar-kets were highly efficient and to underplay the role of interventions thatmay have been necessary to make up for market failures. The following ex-tract from the 1986-b study succinctly presents the Bank's approach:

"There is a growing body of evidence which suggests that thedynamic efficiency losses associated with barriers ofregulatory nature are particularly pronounced. This studypresents evidence that key regulatory policies have beenresponsible for major structural deficiencies in industry,weakly competitive markets, conservative managementbehavior, and significant static and dynamic inefficiency.

14/ The study on capital goods industry (1989-b) finds that, despite theprevailing industrial policies, some 50Z of the industry isinternationally competitive.

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The results underscore the importance of competitive forcesas prime movers of the production frontier in expanding theproductive and innovative capacity of the economy. The slowrate of technical change in India is partly a reflection ofthe fact that the three basic forms of competition --internal competition, import competition and export rivalry-- have to a large degree been absent in most industrialmarkets. Other countries, in their pursuit of industrialgrowth and modernization, seem to have put emphasis on oneor more of these dimensions of competition. Japan andBrazil, for example, have stimulated internal competitionand export rivalry, whereas the Republic of Korea (SouthKorea) has made export rivalry, with a large degree ofinternational specialization, its strategic focus."(para. 05) (emphasis added.)

3.25 Several points need to be made about this analysis. First, the roleof competition as "the prime mover" of industrial development takes incen-tives as the central factor, ignoring (or, at least, under-playing) the roleof capabilities and institutions. This would be valid if incentives by them-selves summoned forth the necessary capability/institutional responses (i.e.the relevant markets were efficient), but not if there were market failureswhich called for distinct interventions. Second, within the area of incen-tives themselves, it seems to be assumed that all competition is desirable:the more the better. However, fully accepting the benefits of competitivestimuli, it is likely that strong arguments exist for intervention to protectinfant industries, realiz economies of scale, promote indigenous techno-logical development, conserve scarce entrepreneurial resources or permit theinternalization of deficient markets. The achievements of protection are notacknowledged. The critical question -- how to balance the need for com-petition with the need to build up long-term national competitiveness -- isnot directly addressed.

3.26 Third, while not in anyway suggesting that India can necessarilyemulate Japan or Korea, the experience of these two countries illustrates theskillful use of interventions in selected product, capability andinstitutional "markets" to build up industrial competitiveness. Indianpolicy makers are well aware that neither Japan nor Korea is a paragon ofnon-interventionism. Their examples may lead to arguments for morecompetition in India, but also for more selective interventions, of aradically different type from that practiced till now. While the detailedrecommendations of the Bank on India (see next section) are much morepragmatic, and take full account of the need for selective interventions, thegeneral analytical approach is unhelpful, perhaps even counterproductive.

3.27 One consequence of this approach is that discussions of industrialpolicy reform tend to ignore issues related to education, training, or insti-tAtional development. The most comprehensive such analysis conducted by theBank in the past 5 years or so is in the CEM entitled "Indiat An Industrial-izing Economy in Transition" (1987-a). Chapter 5 of this report, on the

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*Industrial Policy Reform, Economic Growth and Capital Requirements,, isalmost entirely devoted to the analysis of regulation and the promotion ofcompetition. The discussion is excellent within this contexts conprehen-sive, well-reasoned, pragmatic. But the limits set on the appropriate scopeof industrial policy are revealing: long-term capability development ishardly mentioned.

3.28 At the same time, the studies of technology (1987-b) and exportstrategy (1987-d) do cover some of the relevant capability and institutionalissues. The 1987-b study picks out skill gaps in the management of tech-nology and in manufacturing engineering, and also notes that *not..ithstandingthe national 'surplus' of engineering graduates in India and the relativecomplacency with respect to human resources displayed by several indus-trialists interviewed, it was apparent that several skill areas are relative-ly underdeveloped' (para. xlvii of Summary and Conclusions). It goes intosome detail on the institutional mechanisms needed to support technologydevelopment. Yet these valuable insights are not woven into the fabric ofthe more general analysis: they tend to be fragmented, ad hoc and partial.There is no comprehensive analysis, in the large mass of Bank work on indus-try, of the skill, training, technological, or institutional needs of Indianmanufacturing as a whole. By contrast, incentive factors have been thorough-ly analyzed, albeit mainly with the perspective of reducing intervention allround.

3.29 The data adduced earlier suggest, nevertheless, that there are like-ly to be widespread skill shortages in Indian industry, especially insmall/medium enterprises and in plants located away from major urban centers.In addition, there are likely to be gaps in some specialized technical andmanagerial skills as noted in the technology and export development reports,and, in particular, in the electronics development project (1989-c). Theinstitutional framework that supports various types of capability developmentis also likely to be deficient in various ways. Without some knowledge ofthese factors, the Bank is unlikely to arrive at a full understanding ofIndian industrial performance.

E. Evaluating Government Intervention

3.30 The cogency, incisiveness and depth of the Bank's analysis of theeffects of various aspects of government interventions in Indian industriali-zation have already been noted. Despite the pervasive and often haphazardnature of these interventions, the Bank has done a superb job over the yearsof tracing their incidence and (qualitatively) assessing their impact. Theearlier reports tended to be more sympathetic to the broad strategy of in-ward-oriented interventionism than later ones, but all stressed the damagescaused by excessive protection and internal regulations. The government'sresistance prompted the Bank to sharpen its tools and collect more detailedevidence, but the message has remained surprisingly consistent and valid.

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3.31 The reports on India never vent into the theory of interventions inthe way that Korean reports did. Perhaps the case for reducing interventionswas so strong and obvious, and there was such a long way to go, that thequestion of whether some interventions were desirable and where the lineshould be drawn were irrelevant. Thus, questions of market failure, selec-tive versus functional intervention, or the legitimacy of the infant industryargument, hardly appear in Bank documents on India. While this approach maybe justifiable for practical negotiations with the Indian government, itevades some central questions about industrial strategy that concern the Bankand its policy advice to all member countries. These pertain to the correctstructure of incentives as yielded by the market; the use of selective asopposed to functional interventions; and the appropriate period over whichpolicy reforms should be spread.

3.32 As far as incentives are concerned, the main issues concern tradepolicy. On Indian trade policy, the Bank's analysis of the Indian traderegime, as well as its general stance on trade strategy, is based on thepremise that high, erratic and prolonged protection is inimical to effi-ciency. Its ideal is to have low, uniform protection with brief exceptionsfor industries that have an obvious case for a longer adjustment period.While the case against haphazard and high protection (economically non-selective) is well founded, there are strong reasons to believe thateconomically selective, but high and variable, ERPs may be effective inbuilding up a competitive base in complex industriess as noted, this is trueeven in India with its large dose of offsetting interventions. It is muchmore clearly true of Korea. It is certainly very difficult to disentanglethe benefits of past protection in India from the costs of its non-selective,permanent and haphazard nature and its admixture with other interventions.Bank reports make no attempt to do this, running the risk of misrepresentingthe appropriate role of policy in setting incentives.

3.33 Despite the Bank's normal stance favoring functional as opposed toselective interventions (which is closely related to the recommendation foruniform ERPs), many of its reports on Indian industry come out strongly forselective measures to promote particular activities. Each of the subsectorstudies has a long list of specific measures needed to support competitive-ness, institutions, technology, skills etc. in the activities concerned.The export strategy study recommends backing "specialized and high perfor-mance exporters" (i.e. India's areas of assessed dynamic comparative advan-tage) by various selective measures,15 and of supporting large firms that arevigorous exporters to become even larger (i.e. to copy the "chaebol" strat-egy of Korea's selective interventions). It also asks the government to make"selective investments" to upgrade and modernize key inputs into the export

15/ The measures consist of: (i) providing low or zero duty on importedcapital goods and spares; (ii) improving bonded schemes and zones (EOUsand EPZs); (iii) providing greater freedom in plant location; (iv) givingpriority in provision of infrastructure services; and (v) providingadditional flexibility in employment and labor regulations.

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process.16 The electronics industry sector report (1989-e) specificallypicks out computer software subsector for substantial export growth andrecommends the need to overcome the growing shortage of specialized andexperienced manpower for this activity as well as increasing access to exportand investment financing. The industrial technology development studyproposes that the government procurement procedures be used to encouragetechnical progress. Where government is a major customer, the study suggeststhat '...performance goals be announced well in advance so that firms haveenough time to generate the needed capacity, acquire the necessary technologyand do the requisite R&D. Wider use of product development contracts is alsowarranted, possibly in conjunction with the provision of up-front finance"(para. xvii(2)).

3.34 There are further examples in the automotive products industry studywhere suggestions are made as how to eliminate the negative effective protec-tion on production of certain components *otherwise, component producerswill, for the most part, be unable to substitute efficiency for imports ofmodern components, because they will not have sufficient incentives to under-take the sizeable incremental investments requived to achieve quantum jumpsin production volumes, quality and reliability needed* (para. 18). Similar-ly, the capital goods study (1989-d) has various specific proposals tosupport this sector, ranging from industrial extension servicea, mobile la:sto private metrological services, R&D into processes, and a nei R&D instituteinto metal-forming, to the strengthening of standards, provision of technicaltraining, upgrading of engineering curicula and continuous re-training ofengineers. Other such examples can be found in the various industry studies.

3.35 The Bank's recommendations in the subsector studies are eminentlysensible, designed to overcome market failures that would exist in any devel-oping country regardless of trade regime. Such measures are in a quite dis-tinct category from those intended to remove distortions caused by earlierinterventions (which also have to be selective to deal with selective poli-cies), but are just as necessary. Thus, given the specific support needs ofeach activity, it is difficult to imagine how industrial strategy can betruly functional rather than selective in a developing country. Selectivityis thus inevitable at some or all of various levels: meeting market failuresspecific to each industry (so selectively designing interventions), selectingindustries to support functionally in order to conserve scarce resources, andselecting activities or groups of activities with long-term strategic poten-tial to promote for extra growth (the latter two being forms of 'pickingwinners"). Bank subsector reports on India take for granted the exercise of

16/ Ever aware of the Bank's current objective to the concept of "pickingwinners" the Export Strategy Study is at pain to explain that the-elective recommendations should not be construed as picking winners. Itstates that "As a rule these and other measures recommended would avoidan attempt to pick winners' in exports and offer even-handed treatmentto firms in different industries." This obviously flies in the face ofthe intended attention to be paid to high performance exporters.

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selectivity at all these levels. This is entirely correct, but it is inconflict with the Bank's general statements on this issue, and with its advo-cacy of non-selective protection in India.

3.36 Coming to the appropriate timing of industrial reforms, the 1987-areport has this to says

"The pace of transition is a critical and sensitive element in anyreform package. Time is needed to build new factories and modernize existingones, find and learn new technologies, redeploy workers and assets from ac-tivities that will no longer be competitive, develop new matets (includingexport markets), and find new sources of financing. Too fast a pace wouldraise the costs of adjustment to the point where th4 Government might beforced to reverse the process, while too slow a pace would delay the benefitsof the reform and give rise to resistance to further reforms. There islittle solid evidence on the tradeoff between the adjustment costs and thespeed of the proposed reform, not in the least because the exact size of thelong term benefits of the full package is not known. Other countries thathave undertaken major reforms or programs of sectoral restructuring havetypically decided on a three to five year horizon. As mentioned above, amajor part of the Government's role in the proposed program will involvedevising and implementing firm and subsector level restructuring in India'spublic sector. All this suggests that a minimum of five years would probablybe necessary to carry out the reforms, while a program of more than sevenyears would probably be too slow* (paras. 5.38-5.39) (emphasis added.)

3.37 The early part of the extract is very much in line with the reason-ing of the present analysis, emphasizing as it does the gradual build up ofcapabilities and (implicitly) the development of supporting institutions. Itis the latter part which Indian authorities find unconvincing because of thelack of "solid evidence" on which to base such an important and complex pol-icy package. The experience of 'other coun4ries" may or may not be relevant,depending on the kinds of industries and technologies in question, the levelof existing capabilities and the adequacy of institutional and infrastructur-al support. Vague sweeping statements of the kind quoted above are singular-ly unhelpful to policy makers who have to gear up the whole economy to aparticular sequence of actions. Again, it is the Bank's lack of a comprehen-sive analytical framework that prevent it from even making a plausible at-tempt to address an extremely difficult set of problems.

3.38 The underlying confusion in the Bank's approach on government inter-vention may itself be confusing to governments (this is indeed the case inIndia, as brought out in interviews), reflecting as it does an unresolvedconflict within the Bank between those who believe that market failures arewidespread and need corrective attention and others who believe that existingmarkets are essentially efficient and interventions need to be minimized.The former view pervades most subsectoral and detailed policy analysis, thelatter the more general analyses of policy and macro-oriented reports. Asimilar conflict is present in the relevant development literature, so it isnot surprising that it should surface, albeit in subtle forms, in Bankdocuments.

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IV. BANK'S LENDING OPERATIONS IN INDIA

A. Steel Industry

4.01 The Bank's lending to India's industrial sector started in 1952 witha loan in the amount of $31.5 million to the Indian Iron and Steel Co. Ltd,(IISCO), a private sector enterprise, for the purpose of expanding its steel-making capacity. Since 1952, the Indian industrial sector has received con-siderable financial assistance from the Bank Group through credits and loans.In addition to project credits and loans, the private sector has been as-sisted through many loans to ICICI and IDBI, while 11 industrial import cred-its were approved for India from the mid-1960s to the mid-1970s. The docu-ments pertaining to these loans and credits provide valuable insights intothe Bank's thinking about the Indian industrial sector and the objectivespursued by the Bank.

4.02 The loan to IISCO in 1952 (constituting the fourth loan made toIndia) was followed by five more loans to the steel subsector. In additionto IISCO, another private sector company, Tata Iron and Steel Company Ltd.(TISCO), also received two loans for expansion of its capacity. These loanswere made at a time when the Bank, by virtue of its policy, would only lendto private industry in the developing countries. Its involvement in the ironand steel subsector of India was justified on the grounds of the unsatisfieddemand in the domestic market, availability of raw materials, the economicsof producing steel at a cost considerably below international prices, theneed to conserve foreign exchange and the linkage between steel products andagricultural implements, large irrigation projects, flood control schemes,hydroelectric plants, roads, railroads and finally housing programs.

4.03 During the 1950s the Bank's documents speak in an approving toneabout the result of India's First Plan performance.17 Although the Bank doesnot take issue with the great emphasis placed by the Government of India onthe development of heavy industries in the public sector (especially duringthe Second Plan) the documents were skeptical about the Indian Government'sability to complete three public sector steel plants (Durgapur, Rourkela andBhilai) on time.

4.04 The Bank's involvement with the iron and steel subsector in Indialed to the preparation of a report entitled "Certain Aspects of the IndianSteel Industry" (AS-111a, June 1964 as completed in 1966). While acknowledg-ing the major accomplishments of the Indian Government in constructing threenew greenfield integrated steel plants in about six years, the report drewattention to the shortcomings of the public sector plants. The report spe-cifically noted that "the massive capacity additions also led to many costlystrains, including the need to ensure a stable supply of appropriatelyrepared raw materials and the building up of a staff sufficient in number and

17/ "Although total development expenditures during the Plan period were onlyabout 85Z of the planned expenditure of $4,850 million equivalent inpublic sector, most of the targets of the Plan were achieved and somesubstantially exceeded." para. 23, President's Report to ExecutingDirectors concerning a loan to TISCO dated June 19, 1956.

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experienced in depth, to meet the industry's present and expanding re-quirements." Elsewhere, the report, in discussing the training programs,noted that: 'But these programs could not produce the experience in depth,the 8-10 years' practice it takes to make a good 'steel man', by the time theplant was completedw (para. 16). Based on these observations, the reportrecommended that, given the obvious difficulty of creating the required poolof skills, the expansion of steel-making capacity should be realized in theexisting three public sector and two private sector plants. The commentsabout the high cost of public sector projects and their low productivity wasagain made very forcefully in the Bell report.18

4.05 The Bank also assisted IISCO in 1961 with a loan in the amount of$195 million. This loan was to partially finance a coking coal developmentproject. The following is what the Project Performance Audit Report(No. 2100) had to say about the project: 'Given the Bank's lack of expertisein the assessment of mining projects and its knowledge of earlier differencesbetween the proposals of Powell-Duffryn and ICC on the technical compositionof the mining development program at Chasnalla, the Bank might well haveresorted to a more thorough technical assessment of the program through itsconsultants than it actually did. In its satisfaction with the performanceof IISCO on the steel expansion program, the Bank did not assess clearly thecapacity, managerial and financial capability of IISCO to undertake andimplement a mining development program of the complexity involved inChasnalla under conditions of financial pressure" (para. 9.10). Despite theproblems encountered in the coal development project and the shortcomingsflagged by the industrial consultants hired to appraise IISCO's managementcapabilities, the Bank went ahead to approve a fourth loan to IISCO in June1966. After the approval of the loan, I.SCO's production which had been on adeclining trend, fell again in 1967/68. The Bank suspended disbursement in1969 and cancelled the loan in 1970. In 1972 the Government of India tookover the management of IISCO.

B. Development Finance Institutions

4.06 The second avenue of lending to the Indian industrial sector startedin December 1954. The first loan even predates the legal establishment ofthe Industrial Credit and Investment Corporation of India (ICICI) in January1955. The stimulus to the creation of ICICI came from the recognition thatprivate sector investment during India's First Plan was falling short oftarget due to a shortage of term finance. Since then the Bank has approved21 additional loans to India's Development Finance Institutions for a totalof about US$1.72 billion. The fourteenth loan for $150 million signed in1981 constituted the last general purpose line of credit extended to ICICI.Since the fourteenth loan the Bank has focussed its lending through the DFCsaround key objectives and specific subsectors.

18/ Report to the President of the International Bank for Reconstruction andDevelopment and IDA on India's Economic Development Effort, Vol. VI,Manufacturing 7-! *ustry with Special Reference to Public SectorEnterprise, October 1965.

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4.07 By and large, ICICI has financed viable import substitution projectswith acceptable economic and financial rates of return. Its role in promot-ing projects has been a catalytic one in the earlier years, particularly insupporting projects in less developed regions and those sponsored by newentrepreneurs. Its influence in reshaping the design of projects submittedto it has been considerable through modification in scale, scope, technology,machinery and process selection, etc. Its research department has developedconsiderable analytical capability in economic and sectoral studies whichhave enabled ICICI to influence and contribute to industrial policy formula-tion by the Government and to complement the Bank's own sectoral studies onIndian industrial development.

4.08 From the start of its operations, ICICI has made a worthwhile con-tributioa to risk sharing, the strengthening of financial structure of indus-trial firms and the broadening of the stock market through underwriting stockissues of its borrowers. Besides establishing a leasing company and a mer-chant bank, it also helped establish a credit rating agency in collaborationwith other financial institutions which has safeguarded investor interest insecurities markets as well as helping to improve transparency in comparingfinances. In addition, ICICI has actively supported the enhancement of Indi-an technical and managerial skills by establishing in collaboration with theother all Indian term finance institutions (IDBI and IFCI), a managementtraining invtitute and a network of technical consulting organizations.

4.09 ICICI has, over time, successfully diversified its sources of for-eign exchange funding to include commercial sources so that its reliance onthe Bank's resources is now relatively small. Moreover, ICICI has also mo-bilized local currency resources on its own through sale of debt instrumentson the local capital market.

4.10 Despite ICICI's creditable track record, its effectiveness in devel-oping an internationally competitive modern industrial sector has been tight-ly circumscribed by the Government's trade and industrial strategy. ICICI'sfreedom to alter basic project parameters were severely limited by the highlycomplex regulatory framework. The policy focus on import substitution behindhigh protection and the fragmentation of capacity among several producers dueto the industrial licensing system often led to sub-optimal project designswhich were below minimum economic size, incorporated inefficient and/or obso-lete technology and were non-competitive in both product quality and price ininternational markets. The incentive and the internal regulatory systemsalso inhibited competition among firms resulting in stagnant productivity,limited innovation and high costs.

4.11 Although ICICI has now become a sustainable institution and theBank's contribution to TCICI's institution building was quite substantial(especially during the first decade of the relationship), none of the first14 loans approved by the Bank had any specific sectoral or subsectoral objec-tives. While it is true that they served as a vehicle for transfer of re-sources, simultaneously affording an opportunity for exchange of views onindustrial strategy and policies, the Bank did very little to address theadverse impact of the Government's industrial strategies and policies onefficiency and competitiveness through its lending to financial inter-mediaries. Nor was the scarcity of trained industry managers or the lack of

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information needed to support the efficient development of specific indus-trial subsectors adequately addressed by the Bank until early 1980s. Thissubject will be taken up later, but first we look at the credits and loansfor industrial imports, to the fertilizer sector and to the small scale in-dustries.

C. Industrial Import Credits

4.12 Between the mid-1960s and the mid-1970s, India received 11 indus-trial import credits from the Bank Group totalling $1,330 million. Thesecredits were meant to be a means for India to meet its requirements of capi-tal goods by domestic production from largely existing capacity. A certainnumber of industries had been selected as beneficiaries of these credits.The list of eligible industries changed over time, fluctuating between 6 and13. Industries which remained on the list throughout all 11 import creditswere commercial vehicles, automotive ancillaries, cutting machines and smalltools and electrical equipment. These four main groups accounted together tomore than 50Z of all disbursed import maintenance credits.

4.13 In contrast to project or sector loans, the objective of the programloans was to bring into production unused resources of capital and labor byproviding imported raw materials. In most cases, the Bank would recommendspecific policies which were designed to make more effective use of importedcommodities. Such recommendations often consisted of import liberalizationor the rationalization of tariffs or licensing procedures. In general, non-project lending was not meant to become a soft option or pure balance ofpayments support. The common rationale in most program loans was the inade-quate level of saving in the country to sustain a satisfactory growth in theeconomy and the need for additional foreign exchange resources to financeindustrial imports required for better utilization of exis%ing productivecapacity -- particularly of the capital goode industries to which they weredirected. Inadequacy of foreign exchange resources was explained by limita-tion in export earnings and declining net aid transfers.

4.14 In the case of India, the industrial import credits were somewhatless flexible than a typical. program loan in the sense that they were ear-marked for specific manufacturing subsectors. At the same time, they wereless demanding on the Indian Government than a typical program in the contextof the policy discussions about substantive issues. In practice, a seriousdiscussion of significant policy changes never led to any formal commitmentsand no performance targets were agreed, though in most instances the apprais-al reports contained paragraphs expressing the hope that "it may prove pos-sible to, for example, liberalize imports or stimulate exports -- specificcommitments were occasionally agreed on limited matters such as improvementsin collection of data about licenses and their use, or changes in the pro-cedures of importing agencies, or the preparation of particular studies."

4.15 Among all the credits, the sixth (approved in April 1970) was per-haps the one with the highest policy content. It incorporated in its ap-praisal the need for the Bank Group to "keep under continuous review with theGovernment of India the problems faced by the Indian industry, in particularthose related to IDA-financed industries, and related solutions to overcomethem, including a possibility of (a) the gradual introduction of meaningful

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international competition by permitting the import of banned items againstincreases in exports and recognizing exports as an alternative for GOI re-quirements of import substitution; and (b) encouragement of broader licensingand know-how agreements.. 19 In the eighth credit it was maintained thatsince no in-depth analysis was ever carried out in the industrial subsectorsas a base for meanin%ful recommendations, it was essential to effect suchstudies. As a result, the first two of such reports on commercial vehiclesand tractors were produced in 1973, with another two special reports on steelforgings and on the foundry industry appearing in 1974. As forerunners ofthe two studies on capital goods industry in India which were carried outduring the 1980s, these reports were well prepared and useful in highlightingthe strengths and weaknesses of the specific subsectors. In particular thesereports made proposals to the Government of India to take steps in removingprice controls, improving the allocation of scarce domestic raw materials andintroducing more flexibility into import licensing arrangements. For indi-vidual firms the recommendations covered primarily technical aspectsconcerning product design, technology, quality and costs.

4.16 In the case of commercial vehiclas and tractors, most of the policyrecommendations were implemented albeit slowly. As for forgings and foun-dries, the Government of India experienced considerable difficulty because ofthe large number of firms and the large variety of products involved. Thelast credit, approved in 1976, attempted to respond to the imperatives of themoment and was derigned mainly in support of exports. Thus, a part of thecredit went for financing import replenishment licenses for exporters; anoth-er part was earmarked to support industries which were vital for the economywhile also having export potentidl and the remaining part was allocated tothose industries which were vital to the priority sectors of agriculture andpower. The problems facing the textile machinery industry -- the last sub-sector study -- was never dir-itly touched upon in this last credit.

4.17 Although they helped in effecting marginal reforms in certain indus-trial subsectors, the industrial import credits were really devoid of seriouspolicy content. The credits did assist industries suffering from long-termproblems and aimed at remedying the effects of these problems. but hardlytouched upon the causes. The Program Performance Audit Report for the last

19/ Project Performance Audit Report - India: Four Industrial ImportProjects, September 1975, Report No. 878, para. 1.7, OperationsEvaluation Department.

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credit is quite critical of the Bank Group's lack of insistence to build intothe credits a series of monitorable reforms in order to enhance the per-formance of the industrial sector.20

D. Fertilizer Industry

4.18 The Bank's involvement with the Indian fertilizer industry startedir 1971 with the first credit approved by IDA for the expansion of the Cochinfertilizer plant. Up to that time the Bank Group felt an inhibition in fi-nancing government owned enterprises, but the credit to Cochin probably con-stituted the first project taking advantage of this change in policy. Sincethe early 1970s the Bank Group supported the fertilizer industry in Indiathrough 13 projects with a total financial contribution of about $1.4 bil-lion. The financing has been through IDA for seven projects and IFC and IBRDfor three projects each. These projects aimed primarily at expanding andbalancing the expansion of capacity in the public sector.

4.19 The Bank Group's principal objective was to support India's strategyfor increasing domestic production of basic commodities such as fertilizer inwhich India has a comparative production advantage. The Bank Group's con-tinuing role in the fertilizer sector assisted India in the more efficientprovision of another key input in the agricultural growth process. The Bankhas played a central role in helping to build domestic capacity and in help-ing individual plants to optimize design and technology choice and avoiddelays in implementation and commissioning. Through assistance from foreignlicensors and equipment suppliers, domestic engineering and contracting firmshave been able to build their capabilities to a point where domestic replica-tion of new generation large-scale fertilizer plants is feasible.

4.20. Although the pricing of fertilizer to the farmers always remained anunresolved issue, the loan documents on the Hadhya Pradesh Fertilizer Projectstate that "Overall, Government of India's fertilizer pricing policy (anadministered retention price for the manufacturers and a generally lowerprice to the farmers at the farm gate) effectively meets its twin objectivesof promoting agricultural production by ensuring appropriate incentives tofarmers to use fertilizers while at the same time attracting private invest-ment in fertilizer production and ensuring sufficient financial returns toinvestors" (para. 23, President's Report and Recommendation, April 1984).

20/ Program Performance Audit Report, No. 3508, June 1981, OperationsEvaluation Department. The following is what the report had to say:I...The most obvious obstacle to higher industrial production was theskimpy availability of foreign exchange. While IDA credits contributedto increase this availability the origins of the imbalance in the currentaccount of the balance of payments were and still are in the inward-looking development of Indian industry, resulting in a sharply negativeforeign exchange balance for the sector" (para. 5.05); "...while theindustrial import credits helped in making the course of economicpolicies implemented in India less painful to a number of selected andimportant industries, the Association's economic dialogue with thecountry could have focussed more on the factors underlying thesedifficulties and been synthesized in mutually agreed and monitorablepolicy intentions" (para. 5.08).

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The Bank was satisfied that the Government of India pledged not to take, orcause to be taken, any action which would prevent fertilizer manufacturersfrom meeting their expenses, servicing their debts and earning a reasonablereturn on their invested capital.

4.21 During the 1980s the Bank Group was active in helping the Governmentof India resolve the problems of the fertilizer subsector. The early plant-by-plant studies carried out by the Government and later the FertilizerIndustry Strategy Study (Report No. 6805-IN) highlighted the many areas ofconcern and the ways the industry could be made more efficient. Once againthe problems of technology, efficiency and competitiveness compounded withlack of incentives and decision-making power, lie at the core of this sub-sector's poor performance. The recommendations of the study regarding policyreforms necessary for new investments, restructuring of existent enterprises,pricing and distribution of fertilizers were generally well received by thegovernment which indicated that it would bring about the necessary changes.In addition to attempting the removal of technical problems and bottlenecksin the public sector, the Government introduced an incentive scheme wherebyrewards would be related to production and capacity utilization performance.The Bank is standing on thin ice when it strongly argues for inviting foreignengineering contracting firms in a situation where there are perfectlylegitimate and professional local capabilities and where its own estimates ofa project cost is underrun by 202 as seems to be the case in Madhya Pradeshproject -- approximate actual installed cost equals $425 million comparedwith the Bank's estimate of $544 million.

E. Small Scale Industries

4.22 Since India's independence, the Government of India has placed con-siderable emphasis on developing small scale industries as a means of in-creasing employment, fostering entrepreneurship, developing backward regionsand achieving an improved income distribution. Until the early 1970s, theBank's involvement with industrial development was mainly through ICICI whichprimarily financed large projects in technologically intensive sectors aswell as through direct loans to publicly owned enterprises. Small enter-prises in the early 1970s accounted for roughly 50Z of the value added inmanufacturing and employed about 7-8 million persons constituting a majorsegment of the manufacturing sector.

4.23 Because ICICI lacked a branch network and the sector was alreadybeing served by the National Small Industries Corporation (NSIC) and theState Financial Corporations (SFCs -- 18 in total) as well as the commercialbanks, the Bank decided to offer its financial assistance using IDBI as anapex institution to channel Bank funds through SFCs.

4.24 SSIs in India benefit from an array of incentives: credit at con-cessional terms, hire-purchase schemes, special deductions on income taxesfor priority industries, export incentives, exemption from excise taxes, 152price preference on government purchases and reservation of a large number ofitems for exclusive production, exemption from investment licensing proce-dures and the benefit of the credit guarantee scheme operated by the ReserveBank of India (RBI).

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4.25 In addition to incentives and finances, SSIs also benefitted fromthe services of an enormous network of public sector technical assistanceagencies. At the state level, the Small Industries Services Institute pro-vide a diverse range of technical services including common workshop facili-ties, testing facilities, skill upgrading training, economic information,marketing assistance, etc. These are complemented by the State IndustrialDevelopment Corporations (SIDCs) which also extend term loans, provide mar-keting assistance, process applications for capital goods inputs and distrib-ute raw materials in short supply. In addition all India DFIs have set upTechnical Consultancy Organizations (TC0s) in most states to help promoterswith the preparation of feasibility studies and the choice of products, tech-nology and equipment.

4.26 The Bank's financial assistance came on the heal of a survey carriedout in 1971/72 about the SSI sector. The report21 brought L -t some of thekey issues facing the sector particularly focussing on the various governmentpolicies. It pointed out the problems associated with reservation, scale,allocation of raw materials, sales tax and octroi tax and regional dispersal.The report strongly supported the provIsion of common facilities which wouldallow a large number of small firms to use costly equipment productively.With regard to the existing arrangements for financing SSIs, the report pre-sented an overview which pointed to serious shortcomings in project apprais-al, economic analysis and technical assistance. These observations clearlyhighlighted the prevailing inadequacies and ineffectiveness of the varioustechnical assistance schemes and extension services and underscored the needfor devising comprehensive action plans.

4.27 The Bank's first loan for tSI development (Credit 356-IN) focussedprimarily on strengthening the credit delivery system for the provision ofterm finance. During the preparation and appraisal of this project, the Bankexplicitly recognized the SFC's deficiencies but felt that IDBI could beentrusted with tackling these problems through a comprehensive program ofinstitution buildinj that would help upgrade the appraisal standards andother deficiencies. 2 The second project (Loan 1260-IN) approved in Hay 1976also adopted the same intermediation arrangements.

4.28 Apart from the institutional issues involving SFCs the Bank failedto address the serious problems associated with, e.g., the reservation systemwith its adverse effect on internal competition, product quality, etc. Inparticular the provision of technical assistance to the small industries wasleft out in the design of the loans. As the PPAR concludes, *Although Indiais replete with technical assistance agencies...the projects as conceived anddesigned did not attempt to link and coordinate the delivery of SFC creditwith the delivery of technical assistance at all stages of the project cycle,

21/ Small Scale Industry in India (2 volumes), Report No. SA-33(a), Hay 1972.

22/ An eight part program for SFC upgrading was agreed between the Bank andIDBI/RBI covering appraisal standards, management, organizationalaspects, project supervision, arrears, debt service capability, staffingand training. During 1975, RBI/IDBI developed detailed upgradingprograms for each SFC covering the above areas.

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and sub-borrowers in effect were left to fend for themselves. Such an ap-proach could have been justified if the technical assistance delivery systemin the country was efficient and the sponsors of the subproject sophisticatedenough to appreciate the value of technical assistance. But this was not thecase." Furthermore, there was no explicit link-up envisaged for the SFCs andcommercial banks and the concerns about working capital finance was not seri-ously tackled. Thus, the Bank missed out on an opportunity to influence theSSI development policies. Finally, the Bank came to the conclusion that"after nearly ten years of Bank involvement with IDBI anC the SFCs, this isan appropriate juncture for the Bank to reassess its strategy for involvementin India's small and medium industrial sector" (PCR, para. 6.03).

F. The 1980s

4.29 In 1982, the Bank assisted India with a loan to a paper project inTamil Nadu. This project was conceived specifically to meet the Governmentof India's twin objectives of expanding production of both newsprint andprinting and writing paper and of utilizing bagasse as a fibrous rawmaterial. This project was to break new technological ground as the goal ofproducing newsprint economically using sugar cane bagasse was substantiallyachieved. Though it was not possible to totally eliminate the need for long-fiber chemical or mechanical wood pulp in the furnish, the Tamil NaduNewspaper Project demonstrated the feasibility of the new technology. Inthis project the Bank and the Government of India showed willingness to takerisk and to participate actively in development of an indigenous technologywhich could, once perfected, be exported from India.

4.30 The loan for the Maharashtra petrochemical project (February 1985)is the first in a series that do not explicitly address sectoral or subsec-toral issues, rather that they build on the actions already taken by theGovernment or to be considered as a result of specific sets of studies. Thisproject belongs to the latter category. In the loan documents it is stipu-lated that India has a comparative advantage in the production of convertedplastic products for export because of its favorable geographic location withrespect to its customers, availability of technical know-how and low laborcosts. The Bank agrees with the Government of India in placing the projectin the public sector because of the scarcity of private sector financing fora project of such magnitude as well as the need for optimal utilization ofIndia's gas resources. In the event the Bank only required the Government:(1) to undertake by March 1986 a study of alternative pricing, fiscal andtrade policies for petrochemical-based products; and (2) to carry out byDecember 1985 a study of the export market potential for final plasticsproducts.

4.31 As from the mid-1980s, the Bank's lending to industry became con-siderably more focussed on areas for which a subsector study had already beenundertaken. In addition, assistance to export activities also became acornerstone of the Bank's support. This activity provided the basis for anextended dialogue with the Government the implementation of certain policyrecommendations. But coming on the heels of a wide range industrial sectorreform undertaken during 1985, most of these projects, as mentioned previous-ly, avoided the imposition of specific requirements on the Government, thusattempting to build on what had already been achieved in terms of policy

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reforms. These loans consisted of Industrial Export (Engineering Products),Cement Industry, Export Development, Electronics Industry Development andfinally the Industrial Technology Development Projects.

4.32 The 1985 reforms which touched three major areas -- industrial li-censing, import of technology and export incentives -- opened the way forBank support. In giving the rationale for the Bank's involvement the Presi-dent's Report for the Industrial Exports (Engineering Products) Project,makes the point that 'In discussing the needs for reforms in the industrialsector, the Bank has consistently stated that, where the difficult steps aretaken by the Government to achieve reforms, the Bank would support the initi-atives with lending to finance the resultant stream of costs arising out ofthose initiatives' (para. 59). While the Kapur Committee report (Committeeon Perspective Plan and Strategy for Export of Engineering Goods) recommendeda set of "thrust industries' for attention, the Government's reforms embracedall industrial subsectors for receiving the benefits resulting from the an-nounced changes. The Bank, in consultation with the Government, however,focussed attention on the engineering subsector and came up with a loan thatwas meant to assist export-oriented subprojects through ICICI, engineeringancillary firms (small and medium enterprises) via Government selected com-mercial banks as well as two funds: one entitled Productivity Fund and theother Export Marketing Fund. Both these funds were meant to correct formarket failures by financing up to 50Z of the cost of consultanti, tech-nicians and eligible export development activities.

4.33 The objectives of the loan to cement industry were tot (i) convertwet system plant to dry process and then improve their operating efficiency;(ii) enhance fuel efficiency and improve product quality, labor productivityand marketing and distribution system; and (iii) upgrade plant operatorskills. This loan was based on the Government's willingness to implementmuch of the recommendations of a previous Bank subsector report (No. 3141-IN)by large-scale decontrol of the cement industry and the pricing mechanism.As a result there were no additional reforms required from the Governmentexcept the carrying out of a manpower study and a feasibility study for ajoint training center by the Cement Manufacturer's Association. Again therationale for Bank's assistance is given partly in the following terms: "Bankinvolvement in this project now would confirm that, where environment isconducive to efficient and competitive operations, the Bank could activelysupport the Government in its efforts to modernize and expand industry.'

4.34 The next operation was a loan to ICICI, IDBI and Steel Authority ofIndia. The loan was meant to help the financial institutions weather theadverse implications for their portfolios of the shake-out of the less effi-cient firms as a result of the increased domestic competition as well as therestructuring of many subsectors in order to bring their production costs andtheir quality more in line with international standards. A subcomponent ofthis loan to Steel Authority of India was to be used for preparation ofstudies addressing the physical restructuring of SAIL's operations in orderto bring down the cost of steel production, thus lowering the price of steelto downstream users in the domestic economy.

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4.35 A Second Export Development Loan was approved in March 1988 in orderto sustain the momentum in the rapid growth of manufactured exports, pursuantto the reforms which were introduced earlier in 1985 and subsequentlystrengthened by other changes. The project was designed tot (1) help actualand potential exporters to identify, enter and maintain export marketsthrough assistance for export marketing, product and process adaptation andimprovements; and (2) complement this assistance with term lending for ex-port-related investments. Again, the loan provided frr the establishment oftwo funds namely the Export Development Fund and a Tecnnical Assistance Fund;the former assisting exporters by supplying them with matching grants forcosts of consultants and foreign travel and the latter for improving thefinancial institution's capability to promote and appraise export developmentprograms and export-oriented investments through training of key staff.Clearly, the Bank recognized the need for special assistance to be given on aselective basis to firms in their export promotion activities. The ExportDevelopment Fund was, therefore, designed "to encourage the domestic firms topurchase foreign expertise and information and integrate them into an exportdevelopment program...designed to support individual firms to formulate ex-port plans and to make the necessary investments of time and money in orderto achieve significant increases in exports" (SAR, para. 4.06, Export Devel-opment Project, Report No. 7603-IN).

4.36 Building on the policy reforms introduced by the Government of Indiasince the early 1980s in the electronics industry as well as the recommenda-tions of the Electronic Industry Sector Study (carried out in 1986), theElectronic Industry Development project, approved in May 1989, provided fi-nancing to (a) assist the two largest DFIs improve their capability to iden-tify, appraise and finance sound projects as well as to improve performanceof existing firms in this subsector; (b) assist in upgrading the training ofmedium and high level technical and professional manpower needed for therapid and efficient growth of the industry; (c) help to lay the basis oflong-term continued improvement in the policy environment for electronics;and (d) help to shape India's strategy and prepare projects to support soft-ware development. It is noteworthy that in this project, the Bank addressedthe gaps existing in some technical and professional skills and took measuresto remedy the situation, an approach which has increasingly become a hallmarkof the Bank's approach to industrial development in some countries.

4.37 In response to the Government's emphasis on increased developmentand commercialization of technology relative to basic research; more financ-ing of R&D by the industry; and a greater reliance on technology importsthereby allocating more resources to adaptation rather than duplication, theBank designed a project with the express objective oft (a) helping build theappropriate regulatory and institutional framework for venture capital inIndia; (b) supporting increased collaboration between industry and selectedtechnology service institutions and improving the latter's capability tosupport technological development in industry; and (c) providing industrywith easier and greater access to foreign technology. This project demon-strated how far the Bank's thinking on industrial development had progressedand to what extent there was an appreciation of the need for integratingtechnological development into a comprehensive industrialization approach.

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V. CONCLUSIONS

5.01 Over the years, the Bank has produced work of impressive qualityand quantity on India, perhaps unmatched by its industry sector analysis inany other member country. In many ways, India has brought out the best inBank analysis. The direct impact of this work on Indian policy-making hasbeen relatively small, more a reflection of the attitudes of Indian policymakers and the underlying political economy than of the relevance and ex-cellence of Bank work. However, it is likely that the Bank helped shapethe terms of the economic debate in India, and in particular areas of in-dustrial policy had a significant beneficial impact. The Bank may claimsome of the credit for the recent liberalization, which has, despite itshalting and incomplete nature, boosted growth and competitiveness.

5.02 The major strengths of the Bank's analytical work have been itsunravelling of the intricacies and effects of India's elaborate policy andregulatory framework and its detailed studies of selected subsectors ofindustry. The Bank has been consistent in criticizing some of the ineffi-ciencies inherent in the Indian strategy, but in other respects its empha-sis has shifted over time. Earlier reports were far more supportive thanlater ones of India's inward orientation and emphasis on heavy industry,though both were skeptical of the bias towards the public sector, theconstraints placed domestic entry, growth and competition, and theinadequacy of incentives to export. Later reports attached greater weightto trade strategy and to government interventions more generally,developing a fairly systematic explanation of poor industrial performancebased on misguided, complex and poorly implemented regulations. This themeran through its general policy work as well as subsector studies.

5.03 In practical terms, given the entrenched and pervasive nature ofIndian interventions, this shift appears to be justified. The slow pace ofreform produced by the Indian political system meant that the Bank has tocontinue harping on the need for widespread liberalization in practicallyall factor and product markets. The traditional mistrust with which manyIndian policy makers regard market-determined competition meant, similarly,that the benefits of such competition had to be continually emphasized.

5.04 These practical considerations nevertheless led Bank documents ongeneral Indian policy making into three sorts of weaknesses: on the pre-sumed efficiency of markets; on the role of supporting skills and institu-tions; and on the appropriate role for interventions at the subsectorlevel. On the first, it often appears that markets were taken to be fullyefficient (i.e. no market failures, with competitive forces yielding opti-mum outcomes). There are valid theoretical and empirical objections tothis assumption, as Indian policy makers are well aware, and the Bank'scompletely valid case for "more competition" tended to suffer as a result.

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5.05 On the second, there seems to be a general acceptance in Bankdocuments that India had a *surplus* of high-level skills, though occasion-al note was taken of specific skill shortages. Comparisons with otherNICe, especially Korea, do not suggest that this is justified. There mayhave been large areas of Indian industry that were operating with lowlevels of technical and managerial skills these deficiencies were notimmediately obvious because of the other constraints and protection underwhich industry operated. Despite the significance of skill development toindustrial efficiency, there was no real analysis of this relationship inthe large volume of Bank work in India. The role of institutional supportfor industrial development received somewhat more attention, especially inthe context of export promotion, financial sector and technology policy.This analysis was useful and cogent, especially in pointing out weaknessesof existing institutions. However, there is still lacking a systematic andcomprehensive analysis of the institutional needs of Indian industry, tostrengthen markets, remedy deficiencies in information flows, risk bearinginnovation, training and so on, and achieve coordination among the actorsinvolved.

5.06 The third weakness of the Bank's analysis follows from the pre-vious two. If there existed market failures in product and factor markets,there may have been a valid case for government intervention. The natureof that intervention would have depended on the nature of the market fail-ure, the potential for market-driven (non-interventionist) solutions andthe capability of the Government to intervene efficiently. Issues of thissort were not, however, explicitly discussed in Bank reports on India.There tended to be a confused outcomes many of the general policy docu-ments were strongly critical of interventions in most forms, while otherssupported various forms of intervention. Subsector studies were normallyexplicit in favoring widespread and selective interventions to enhancecompetitiveness, while recommending considerable liberalization on domesticand foreign competition.23 This unresolved conflict between arguments forand against interventions was an analytical weakness in the Bank's work.It reflected the absence of a comprehensive framework for analyzing indus-trial development which would systematically cover its major determinantsand potential market failures in promoting each determinant.

5.07 The Bank has tended, along with the larger academic developmentcommunity, to use the Indian case as one of the the prime examples of inef-ficiencies created by government intervention. There is no doubt that theIndian regime bears much of the blame for its poor industrial performance.However, this regime has not practiced economically selective interven-tions, and it is a mistake to criticize the case for such interventionsbecause of the Indian experience. Indian interventions have not been de-signed to be economically selectgve, and even their non-selective thrust

23/ 'Infant industry" considerations are not brought in, presumably becausethe activities concerned have been in existence for some time; but thisdoes not take account of the needs of new entrants.

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has been weakly supported (by skill and institution building) and poorlyimplemented. Some economically selective elements persist nonetheless, andaccount for the fairly broad smattering of efficient activity across theindustrial structure. The Bank acknowledges these successes, but does notlink them to the relevant interventions. This explains the Indian reactionthat the *achievements* of its industrial process are not acknowledged bythe Bank.

5.08 In sum, the Indian industrial experience calls for a more subtleand qualified analysis than the Bank has meted out. Such an analysis wouldprovide a more coherent and rigorous basis of recommending policy reform.The principal direction of reform would not change, and policies would haveto be liberalized to allow much greater play to market forces and to scrapcounter-productive controls. However, a number of interventions, bothspecific and functional, would have to be instituted (or improved) toensure that the appropriate competitive response takes place. Bank reportson India often draw on the Korean model to extol the benefits of export-orientation and liberalization; they should be consistent and also draw onthe Korean model of interventions to support industrial deepening and up-grading.