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From Licence Raj to trade openness, it has become quite apparent that India has transformed significantly into a growing economy. The adoption of lucrative policies and changes within the political system over the last two decades, indicate that economic activity seems to have flourished. The main aim of this dissertation it to explore the question of, does import liberalisation hurt the performance of domestic firms and what are the effects on exports.
By simply introducing new trade policies and adjusting existing reforms, the project aims to examine whether the Indian government has been able to achieve growth in trade within the domestic economy, bearing in mind the effects on performance of domestic manufacturing industries and the repercussions on exports levels. Although there have been a number of studies related to the effects of import liberalisation on domestic industries, many of them had been conducted several years ago for that reason the empirical and theoretical results may not cover the more recent changes in reforms and trends in trade data. Therefore my research will be aimed at discovering whether the new reforms in favour of import liberalisation, hamper growth and performance of domestic firms in India in light of the recent changes in the domestic and global economic climate. In addition, the report will also be analysing the affects of the new trade policy changes on the export levels of the domestic economy. The availability and use of up to date data on the variables selected for this report, will also give an opportunity to provide more detailed account of the data trends and results of the econometric modelling. Moreover, the use of data ranging from 1950-2008 will also help draw better conclusions based on the hypothesis of this report.
The vast amounts of literature relating to this topic present different arguments and illustrate differences in outcomes. For instance, a study conducted by N.S. Sidharthan and B.L. Pandit (1998) find that the majority of domestic industries reacted positively to the policy changes on trade liberalisation and import tariffs, and had shown rapid growth in their sectors. Moreover, those who favour trade liberalisation believe that it has numerous advantages to firms operating in various industries. For instance, one of the main advantages is that local firms would become more resistant to foreign competition. It is also widely argued that openness to trade encourages foreign direct investment and off-shoring by multi-national companies, which results in spill over effects and increase in export levels. Furthermore, Mohanty (2003) emphasised that the reductions in tariff policies have increase overall exports within local industries. Nevertheless, some critics still argue that domestic industries may not be able to fully benefit from the efficiency gains derived from import liberalisation. Since it may be challenging to adjust to new foreign technology being imported, hence local manufacturing firms may not be capable of producing goods that are of international standards. Moreover, due to financial restraints the majority of local firms may not be able to meet the expense of importing new technology and services in order to improve productivity and efficiency. In addition, research conducted by Balakrishnan, Pushpangandan and Babu (2000) emphasised that during the trade liberalisation era, the reduction in import tariffs have not improved the performance of local firms. Moreover, there still exist a small number of sectors that suffered heavy losses due to the policy changes, which was mainly due to regional disparities amongst states. More detailed discussion based on the issues surrounding the strengths and weaknesses of import liberalisation and exports is provided throughout the report, and covered extensively within the literature review.
The opening chapter of this dissertation will provide a review of the economic development in Indian. The second chapter will give an assessment of the dominance of the 'license Raj' in Indian economy. The third chapter will be based on the criticisms of industrial licensing era. The fourth chapter will review the history of trade liberalisation in India. The fifth chapter is based on challenges of trade liberalisation. The fifth chapter will provide a review of tariff rate policies in India. The sixth chapter discusses the strengths and weaknesses of the New Economic Policy (NEP). The eight chapter will be based on the rationale for trade and development. The ninth chapter provides a critical literature review based on trade liberalisation. The tenth chapter will provide an analysis of the selected economic variables. The twelfth chapter will cover the empirical analysis of the data series. And finally, the last chapter provides an overall conclusion for the project. Additionally, Appendix A will provide the results of the econometric tests, and Appendix B provides the data tables.
Review of Economic Development in India
This section of the report will examine the timeline of key economical and political events that took place after India had gained its independence. The basis for choosing to study the economy post independence was because prior to this the economy was under colonial rule, hence the government did not have any control over policies and reforms that would help improve the economy.
In 1947 India finally gained freedom from British Empire which was major breakthrough for the national government and the citizens of the country. In addition, it also paved the way for the government to draw up much needed plans that would help kick start the troubled domestic economy. One of the first propositions made by the Indian government was in early 1950s, when they had decided to pursue a five year plan based on import substitution process. The main aims of this strategy were to protect domestic producers from international competition and also help the growth of infant industries. Moreover, all the reforms and policies were under the strict supervision of the government and were accompanied by bureaucratic red tape, which made it almost impossible for multinational companies to engage in foreign direct investment due to the high entry barriers to trade. Additionally, the complex structure of government also proved to be a major impediment for the development of new domestic firms. Consequently, the Indian government had failed to succeed in the implementation of their import substitution policy, since there were many drawbacks of such policy which led to economic inefficiency and the misallocation of resources within the economy.
Having been unsuccessful with its import substitution plan, the 1980s was when the Indian government decided to revise its policy reforms with regards to trade, and hence decided to open markets to international trade through liberalisation of a few domestic sectors. Despite the new proposed measures import liberalisation was still shadowed by a degree of protectionism with regards to high tariff rates and licensing requirements, hence domestic firms were unable to fully benefit from the transfer of new technology and capital acquired through foreign direct investment. Moreover, during the course of the mid 1980s and early 1990s the economic outlook had worsened, since the Indian economy suffered from a major financial crisis along with several macroeconomic problems. The crisis was as a result of the overvaluation of the Indian rupee and major deficits in the balance of payments, which consequently led to a fall in consumer confidence and severe devaluation of the currency. Amidst the economic crisis, the government also had to tackle high levels of poverty and unemployment, which had negative impacts on the domestic economy.
Moreover, even after the removal of quantitative restrictions and the reduction in tariff barriers on most goods and series post 1991, consumer goods were still heavily protected by the government through import licensing laws. Consequently, this led to a number of big domestic firms gaining monopoly power over particular goods that were prevented from being imported. Therefore, the majority of the domestic producers were placed at a disadvantage as they had put up with bigger firms who had total control over the prices and quantity of the goods being manufactured. Hence, with regards to the general performance of firms, it had become quite clear that import licensing policy failed to improve the productivity and efficiency of local manufacturing firms, since most of the markets for these goods were dominated by monopolists. Though the government gradually removed some of the licensing restrictions on a number of commodities, there was still a majority of goods that were still protected by tariffs and import licences. This pattern carried on throughout the early 1990s, however by the beginning of the new millennium India had abolished all restrictions on placed on the imports of goods. The main factors responsible for the changes in these protective polices, were due to the pressure placed on the Indian government by the international organisations, namely the IMF, World Bank and the Uruguay round organised by the World Trade Organisation (WTO). Having briefly highlighted some of the main stages in the trade development process of the Indian economy, the following section will explore in more detail changes in the trade policies used by the government in the build up to trade liberalisation.
Dominance of 'License Raj' in the Indian Economy
After gaining independence in 1947 India showed very low signs of economic growth and development within its economy. One of the main arguments for the bad performance of the economy was strongly related to the culture and traditions of the Indian people, which was also often termed as the Hindu rate of growth by some economists. In addition, the government decided to operate in a closed economy with almost all the main sectors of the economy being regulated by the government using the licensing policy. This led to the emergence of the term 'License Raj', which meant that all domestic firms were given five year plans in order to achieve set target levels of production, and were protected from foreign competition under the licensing umbrella. The main objectives of the licensing initiative which had been implemented by the Industrial Policy Resolution, was to gradually improve inequalities in income and wealth, prevent creation of monopolies, boost overall economic performance and growth of industry. Nevertheless, the requirements that had to be met in order for new companies to obtain an industrial license were rather over ambitious, and provided many problems for development local firms and the growth of industry as a whole. One of the main obstacles was the very lengthy time period for applications to be processed, which lead to slow progress in the start up of new firms. Moreover, the lack of corruption and bureaucratic structure of the departments dealing with new applications, resulted in the more established and big firms being given first priority over majority of small and medium sized enterprises. Nevertheless, there was still a relatively greater number of applications that had been approved, the economy lost out to the declined firms who would have contributed to overall investment and growth within industries. In addition, the lengthy time span for the average application to be process proved to be another reason for the slow growth of domestic industries, since it was discouraging to those who were keen on setting up new businesses.
The notion of industrial licensing was introduced when the government decided to approve the new Industrial Development Act 1951. This was a crucial phase in the development of the political economy of India, since the nation had recently gained independence and was seeking to revive the troubled domestic economy. Furthermore, the main aims of the new law relating to industrial development was to put into practice new industrial policies, to assure the development and regulation of main industries, and finally to expand and develop new and existing industries. The second five year plan which was implemented during 1956-1961, introduced the notion of import substitution within the economy. Yet again, the newly revised policies still led to more problems with regards to improving exports within domestic industries, since manufacturing firms were unable to import new capital in order to improve productivity and competitiveness. The third five year plans, the restrictions on a number of imports were lowered in order to help modernise the economy. In addition, the problem with exports had been given priority; hence the new export promotion initiatives were offered to local firms. Although, these policies were very much in practise throughout the 1970s and 1980s, they were consistently altered by different parties in control of the government over these years. For instance, in 1985 Rajiv Ghandi's trade and finance department decided to reduce licensing restrictions and liberalise a vast number domestic industries, in an effort to help kick start industrial growth. The outcomes of such policy changes led to many of the sectors of the economy becoming privatised; hence there was flow of foreign resources and capital into local markets.
Furthermore, it can be argued that these new modifications made to the trade policies, provided the opportunity for local firms to become more modernised and efficient. Another main benefit of the new policy changes was that, local manufacturing firms were given the choice of producing a variety of products rather than manufacturing homogenous products. This enabled domestic firms to broaden their sources of production, and hence engage in more R&D and achieve greater productivity. Moreover, in an effort to improve trade even further and increase the pace of industrial growth, the trade policies protecting industry were yet again revised by the new government during the period of 1988. The Dal administration decided to de-license many more industries, which subsequently increased the liberalisation of importing inputs by a further 15 percent. In addition, other incentives given to local firms also included deductions in tax rates for domestic industries, which helped firms to increase profits and also encourage the start up of new businesses by new entrepreneurs. Furthermore, the new trade policy also placed huge emphasis on helping the rural and agricultural sectors of the economy, which were experiencing huge losses as a consequence of trade liberalisation.
Criticism of Industrial Licensing era
Since its introduction in early 1950s the 'License Raj' had been subject to many modifications over the four decades that it had been in operation. Moreover, during this period its overall success on the economy had been subject to extensive criticism, with only a very few who seemed to have appreciated and acknowledged the policy. Hence, this section will explore some of the arguments made for and mainly against the licensing policy.
One of the first arguments that stems out against industrial licensing, was the fact that not all geographical sectors of the economy were provided with equal provision. As a consequence, this led to many industrial sectors being dominated by big firms who easily gained monopoly power. In addition, the high restrictions on import policies at the time prevented local firms from importing the technology required for achieving successful modernisation and growth within industry. Moreover, the licensing policies had also led to increase in the level of bureaucratic red tape and corruption within the authorities dealing with applications. This was seen as a major disadvantage to growth and performance of local firms, since it discouraged the start up of new firms and the corrupt system meant that the relatively big firms would be able to buy out industrial licenses at the expense of the majority of small manufacturing firms. Thus, there was a widening gap in equality amongst domestic industries, as it became quite clear that the bog firms continued to expand and grow while new and existing business were being deprived of such privileges. Having analysed some of the key criticisms of the 'Licence Raj' era, it is fair to say that almost every aspect of industrial activity had been subject to restrictions one way or other. Therefore, it can be argued that even though licensing protected domestic industries from foreign competition, it had adverse affects on the performance and growth of local firms. Nevertheless, one must not forget that at the time of gaining independence and becoming a free state, the implementation the licensing policy was a vital step for government to take, in order to better regulate and manage the domestic economy.
The numerous problems encountered in the licensing policy led the government to revise the strategy, and new measures that would make it easier to apply for a license were introduced. Despite these changes, it had become quite evident that the licensing strategy had still failed to help improve the troubled domestic economy.
History of Trade Liberalisation in India
There were many reasons that led the Indian government to choose to open its markets to foreign trade, and more importantly to introduce import liberalisation. In this section of the report, we will analyse some of key factors that lead the government to bring about the significant changes in trade reforms.
The new elected government of 1991 were faced by a number of escalating macroeconomic problems which had virtually led the domestic economy into crisis financial crises. Some of the major problems experienced by the troubled economy were the sharp increase in the inflation rates, high unemployment figures, deteriorating foreign exchange reserves and a deficit in the balance of payments. Amidst all these growing problems, the major international organisations such as the IMF and the World Bank decided to bring to cut off the financial aid provided to the Indian economy. This was a seen as a major blow to the government, since these institutes acted as a lender of last resort to the country. In addition, a vast amount of gold was deposited by the government at the Bank of England in order to prevent the economy from further financial crisis. Furthermore, the overall growth rates of industry were in decline, which meant that more and more firms were becoming victims of the troubled economy since they could no longer afford to operate. The lack of government funds meant that the infrastructure of the country was also deteriorating, which hampered any efforts of encouraging growth within domestic industries and also attracting FDI activity.
Hence it had become quite clear that the economy had shown all the symptoms of a recession, therefore the government had to bring about certain changes with regards to devaluating the currency, privatising industries and last but not least to revise its trade policies, in order to kick start the growth of the economy and increase its competitiveness. Moreover, the adoption of the new outward orientated policies by government had proven to be very beneficial to the economy, as it firstly it enabled the flow of new capital by international investors and secondly the policies also provided special packages to the troubled domestic firms. However, the new trade policies also had some negative impacts on domestic industries and individual firms. A detailed discussion based on the counter arguments on trade liberalisation is provided in the following sections of the report.
Moreover, significant dismantling of the licensing policy was undertaken by the newly appointed government which was headed by Rajiv Ghandi in 1985. The first sign of changes towards trade liberalisation occurred when the new government decided to remove licensing barriers from more than twenty different sectors of industry, and hence open up domestic markets to foreign trade and competition. However, this approach raised many concerns amongst critiques since there was a degree of uncertainty as to how local firms, who were previously under the protection of government legislations, would react to the foreign markets and more crucially how it would impact the performance levels of domestic firms. Another counter argument made against the new trade reforms was that import liberalisation would lead to a sudden surge in imports, which will lead to greater international competition and would harm infant industries. On contrary, many reports seem to indicate that the majority of domestic producers were able to deal with the challenges of competition derived from trade liberalisation. Furthermore, the new measures were only operational until 1991 and had a rather short-run effect on industry growth; the main reason for this was due to the assignation of the current president. Hence, a newly replaced head of state along with new ministers' from the same political party were sworn into parliament during the same year.
The new Prime Minister Narasimha Rao was faced by the overwhelming task of improving the several economic problems the nation was experiencing. Therefore, the government decided that there was an urgent need for a change in reforms and therefore decided to pursue a new set of policies that would be in favour of liberalising trade within the domestic economy. The first step taken by the government was to abolish the licensing policy which had failed considerably in achieving its aims and objectives, with the exception of a few industries that were still protected due to national security, environmental and public safety reasons. Moreover, some of the main aims of the government with regards to engaging in complete trade liberalisation were to, firstly liberalise domestic industries from licensing approvals, secondly to support improvements in local technology through imports of foreign technology, thirdly to attract foreign direct investment from MNCs by opening the economy, and finally to reduce the laws that were preventing local firms acquiring new resources, technology and knowledge. The trade liberalisation policies also offered automatic clearance on imports of goods and services made by foreign companies, which attracted more FDI and also encouraged the growth of different industries. However, the extent to which these policies have helped the efficiency and growth of local firms competing in the same industries as their foreign counterparts has raised concerns. Many argue that, such policies have made it easier for MNCs to take control of domestic industries by importing new technologies and capital that local firms may not be able to afford or gain access to; hence local markets may be exploited to foreign competition. Under the new trade policies post 1991, the government also decided to take a few measures in order to help exports and encourage the growth in domestically produced consumer goods. The first step by the government taken in an effort towards increasing exports was when the government removed licensing restrictions on number of domestically produced products. Secondly, Export Processing Zones (EPZs) were also set up in various attractive locations in order to boost foreign investment and more importantly increase exports. In an attempt to increase the confidence of local firms and new investors in the domestic economy, the government also implemented new favourable reforms within the financial sector. The new policies made it easier for firms to take out loans at considerably lower interest rates, and the whole banking regulatory system had become more desirable. Moreover, after the first three years the new reforms were able to help stabilise inflation from 17% in 1991 to 9%. This was beneficial to both consumers and local manufacturers, since low production costs would mean that goods can be produced at a low price and hence consumers can increase their consumption of those goods. The substantial growth in GDP was also another clear indication of an increase in overall production between domestic industries.
From the significant changes that took place from 1991 till present day, it can be argued that India has geared towards becoming a free market economy. However, the extent to which these new trade policies have affected domestic industries and the performance of individual firms still largely depends on the effectiveness of India's information and telecommunications, transportation structure, availability of natural resources, and more importantly a healthy and anti-corrupt government. These factors play a crucial role in the modernisation and growth of the economy, and also give India the chance to improve its reputation as an attractive host nation.
Challenges of Trade Liberalisation policies
Having explored the brief history of the licensing regime and the gradual build up towards trade liberalisation, this section aims to examine some of the challenges the domestic economy of India may face, with regards to changes that were made to trade policy during 1991. An assessment of these factors will help paint a clear picture with regards to how local firms and industries in general have reacted to these new reforms, and more crucially to identify whether overall benefits outweigh costs or vice versa.
One of the first factors that need to be studied is to see whether the domestic industries are able to preserve a consistency in growth rates during the gradual modernisation and development of the industry. It is worth mentioning that at the time when trade liberalisation policies were initiated, the Indian economy was still in recession. Hence, declining production rates and rising budget deficits meant that local firms were not able to improve productivity, and therefore there was a decline in the growth of industry. Moreover, a fall in the demand for consumer goods and a cutback in overall private and public investment gradually led to downturn in overall export levels. However, despite these tough challenges the government had to face, the performance of the domestic economy seemed to have improved significantly towards the mid 1990s and early 2000. There was a surge in FDI activity and the majority of domestic industries were beginning to experience higher productivity and growth rates.
In addition, another important factor is operating in an open economy with very low barriers to entry, which can also trigger different reactions with regards to the response of domestic industry interacting with global markets and facing foreign competition. For several decades the domestic industries of India were under the heavily protected umbrella of the government. Therefore when trade liberalisation and other free trade measures were introduced, local firms were faced the huge challenge of dealing with intense foreign competition. In addition, the quality level of goods manufactured by local firms were generally of a very low standard in comparison to international products, hence it became an even more difficult challenge for manufacturing firms to re-establish their products in order to rival their counterparts. In addition to these obstacles faced by the economy in light of the trade liberalisation era, international competition also had adverse effects on the levels of exports of domestically manufactured goods. In return, this would also have an impact on the balance of trade for the exporting country, since the goods produced locally may not be desired in foreign markets; therefore imports may exceed exports and can to a trade deficit. Nevertheless, import liberalisation measures have since helped the majority of domestic industries to enhance their methods of production by improving technology and acquiring new methods of production. In addition, a rise in FDI activity in domestic markets has also helped local firms benefit from spill over effects.
Furthermore, during the initial stages of trade liberalisation period the lack of investments made on research and development by local firms were very low. Hence the majority of manufacturing firms were unable to gain comparative advantage when competing against foreign industries that produce similar products. Moreover, if local firms engage in research and development activities, they are more likely to accumulate new innovations that could help improve their efficiency and productivity levels. In addition, the use of new methods and technology can also provide domestic industries with the opportunity to produce highly specialised goods that are more distintictive. Furthermore, the use of natural resources and the relatively cheap labour can also be a driving factor for local firms to cut back on production costs and increase output. One of the socioeconomic benefits of liberalisation era has been that a mere 300 million people were helped from poverty, Doing Business in India report (2009). This helped the start up of Small and Medium sized Enterprises (SMEs) in the rural areas where poverty was high, hence more job opportunities were created for the local people. Moreover, there has been a general increase in the literacy levels amongst people living in India which results in a more specialised labour force, this was also beneficial to domestic firms who were able to become more competitive and innovative.
However for all these positive effects to take place, India had to make sure it had an attractive domestic infrastructure, high literacy, access to raw materials etc. On the whole, the main question with regards to the extent to which these significant changes in trade reforms have helped improve the overall performance and resistance of local firms and exports, will be discussed in more detail in the following sections of this report.
Review of Tariff Rate Policies in India
Over the last decades there has been a continuous growth in the number of developed and developing nations engaging in domestic production and international trade. Moreover, the progress and growth of trade amongst different nations is also accompanied with a set of trade barriers. Although trade barriers are imposed to protect the local industries form the threats posed by international markets, many countries such as India have since engaged in reducing these barriers into 'fair trade laws'. This chapter will give a review of the changes that have been made with regards to import tariffs and export duties.
Prior to the trade liberalisation reforms the government had implemented high quantity restriction on foreign trade. The main aims of adopting this policy was to control flow of international trade and more importantly to protect domestic industries from foreign competition. However, towards the mid seventies the government decided to replace the high quantity restrictions with tariff rates, because the method of import substitution and quantity restriction policies had failed to achieve growth within the economy. Therefore, the significantly high tariff rates imposed by the government were ultimately adapted to carry on protecting the domestic industries from being exploited to foreign competition and to encourage the growth of emerging manufacturing sectors. In addition, the tariff rates were also set at a high rate in order for the government to generate more revenue from the import of goods. However, at some periods the tariff rates had reached highs of 300 percent, which was deemed too high and unfeasible for the growth of economy.
Moreover, during 1985 the government decided to acknowledge the importance of lowering tariff rates, since it had become more costly to import raw materials and other products that were used to manufacture products that were exported. Therefore, under the long term fiscal policy declaration the government decided to lower the rates on imported goods that were deemed as essential to the manufacturers and consumers. The Finance Act in 1987 provided further reductions in the tariffs rates placed on capital goods, in an attempt to increase the levels production amongst domestic industries. However, one of the major flaws in the tariff rate changes was that it did not seem to benefit all sectors of the economy. For instance, the majority of the population were working in agricultural related industries; hence reductions in tariff rates had little effects on improving production and exports within that industry. The following year the Finance Act was yet again revised, the import duty rates were reduced from 93 percent to 87 percent and the tariffs on the import of capital goods were lowered for several industries. In general, despite the reductions in import duty and tariff rates, there was still a degree of bias with regards to the fairness and benefits of these policy changes. Therefore it can be argued, in economical terms the so called fair trade laws that are implemented by the government in order to encourage fair trade and economic development, are actually hampering this process in the case of the Indian economy.
Therefore, under the control of the new government headed Prime Minister Narasimha Rao finance Minister Dr. Manmohan Singh, the Tax Reforms Committee was appointed to analyse the problems with import tariffs and custom duties, and bring about new changes that were required. As part of the changes that were planned to take place, the committee had highlighted several fundamental factors that needed to pursue in order to help improve economic growth and the performance of all industrial sectors. One of the first factors highlighted was the need to reduce the general tariff levels, which in effect was still crucial as it was affecting the performance of many infant industries. There was also emphasis placed on the need to abolish the distribution of tariff rates amongst various industries, so that there could be one tariff for all sectors of the economy and also to reduce the complications of the import policies. In addition, almost all tariff related incentives offered under previous reforms were all abolished, in order to eliminate favouritism between the industries that were growing faster than some of the slower ones. Having outlined some of the proposed plans to the tariff and duty rates, it is fair to say that the effects of such changes would require a fair amount of time in order for the economy to grasp and benefit from. Throughout the 1990s and into the new millennium further reductions were made to tariff rates, with more emphasis placed on reducing the duties on goods imported for manufacturing and domestic purposes. More specifically, from start of trade liberalisation in 1991 till 1995 the tariff rates had been reduced from a mere 400 percent to 50 percent, Rana (1997). In general, it can be argued that the initial use of tariff rates was mainly imposed in order to protect domestic industries from competition. However, with the transition of the economy since the mid 1980s, the mind frame of the government had changed in favour of cutting back tariff rates in order to provide a chance for domestic industries to become more competitive and also improve productive efficiency amongst firms.
Having thoroughly examined the tariff process with regards to imports of goods and services into the domestic economy, this section will now give an overview of policies relating to export duties. To a certain extent, exports have had influential role on most of the domestic industries in India. The main reason behind this is due to fact that the economy has a comparative advantage over a few goods that include tea, rice and textiles. Therefore, in theory the these particular sectors of the economy have some characteristics of monopoly power, which provides the government with the opportunity to set high export duty rates and generate high revenues. During the 1950s and early 1970s the revenue generated from export duties had reached highs of 30 percent of total customs takings. However, the emergence and modernisation of less developed economies had led to more competition within these sectors, which results to ultimate reduction in duty rates. In general, over the last few decades the duties on exported goods have significantly reduced due to international pressure. It seems that the government has also adopted low export duties in order to attract foreign investments, and more crucially to make domestically produced goods more desirable to foreign importers. The process of export promotion had been widely used by the government in attempt to increase exports of domestic goods. This also led to the introduction of EPZs in selected states, which enabled foreign firms to engage in complete FDI and benefit from tariff and duty free exports and imports of manufactured goods. Under the export promotion plans the government had also set out additional funds to improve the infrastructure of the economy, which was crucial increasing trade. In addition, export duties are still widely used by the government as a tool to protect domestic manufacturers from price wars that are implemented from foreign markets. Moreover, in order for the government to be able to better regulate policies regarding imports and exports, the Foreign Trade Development and Regulation Act was introduced in 1992. The new act was beneficial to domestic manufacturers, since it enabled the government to effectively adjust rates in order to improve the efficiency and performance of domestic industries.
New Economic Policy (NEP) - Strengths and Weaknesses
The New Economic Policy (NEP) was a newly implemented government programme which was initiated during the mid 1970s. This new plan was built on five main policies that the government had chosen in order to help the economy become more energetic and productive. One of the first policies emphasised by the government was the need for trade liberalisation within the economy. This policy was very crucial for the improvement of the economy and the efficiency of domestic industries, since its main tasks were to ultimately eliminate licensing requirements, quantity restrictions, high tariff barriers, and restrictions on foreign investments. Moreover, the other policies that were also included in the frame work of the NEP were based on encouraging privatisation, free market economy, globalisation and transfer of technology. In addition, it can be stated that all these policies chosen by the government made up the basic foundations for the economy to be able to revive itself from the major economic downturns it was facing, and ultimately increase the productivity of domestic industries. Although the centrally planned economy which operated during the 1950s till early 1970s had failed to bring about major improvements within the economy, the NEP policies was widely used by the government and became subject to several alterations since its introduction in 1975. The report will now look to examine some of the key events that took place with regards to changes made to the NEP and the outcomes achieved through the performance of the economy.
During 1975 the first initial step was taken by the government with regards to the adopting the notion of free trade and liberalisation process. During this year, more than twenty industries were for the first time made exempt from licensing laws and were able to expand the levels of production and total output beyond the restrictions. In addition, the new changes also allowed MNCs to invest in the newly opened industries, and therefore help improve productivity and efficiency of local firms mainly through mergers and acquisitions. The main aim behind this move taken made the government was to encourage greater expansion of domestic industries, and to encourage foreign investment which would be beneficial to local firms. Furthermore, after the first three years of opening up industries to foreign trade, the government decided to significantly reduce the laws on the imports of raw materials, machinery and other goods that were used in the manufacturing process. Hence, by 1979 import liberalisation was in full operation amongst the selected industries, which enabled local firms to import new machinery in order to increase efficiency and ultimately enhance exports. However, one must not forget that during this period the majority of firms were still relatively poor and therefore were not able to import new capital from abroad. Hence, there were huge disparities between the normal firms who were unable to expand for financial reasons, and the big firms who had established strong links with foreign companies.
Moreover, towards the beginning of the 1980s additional changes were made to the trade liberalisation policies. For instance, in 1982 the chances for new firms to gain an industrial license were made very simple and easily accessible. In addition, the rules and regulations were significantly lowered which meant that most of the new firms were able to operate in specialised industries that were previously heavily monopolised. Towards the mind eighties further reductions were made on imports, which increased the amount of foreign investments and led to the privatisation of many domestic industries. In addition, import liberalisation provided local firms with easy access to foreign capital and adopting new methods of production, this in turn increases the ability of domestic firms to fully utilise their capacity effectively. Nevertheless, though there was huge emphasis placed on liberalising imports in attempt to ultimately increase exports, there was still a relatively huge deficit in the balance of payments for the Indian economy.
In a bid to reduce the differences between the favoured industries and slow growing rural industries, the government provided huge tax break to firms who would set up manufacturing in these so called troubled sectors. For example, in 1985 new policies enabled firms who operated in these areas to be entitled to a 20% deduction in their income tax. Moreover, the all products being imported for the purpose of manufacturing exported goods were exempt from all customs and duty charges. By late 1988 the government had announced further reductions in the policies related to exports and imports, in order to help improve the performance of local firms and increase export competitiveness. Furthermore, by 1990 Export Promotion Zones were set up in low growth sectors of the economy, in order to encourage Greenfield investments and eventually increase exports. Despite all these measures taken with regards to tailoring trade policies to improve economic growth and performance of local firms, the government was still under immense pressure with regards to huge economic problems which had led the economy on brink of recession.
The pressures of a failing economy was building up on the government, hence the new industrial reforms were announced in 1991 in a desperate bid made by the government to revive the troubled domestic economy. One of the drastic changes made to the trade policies, related to the elimination of all limitations that were placed on exports and imports. This was done in an attempt to boost the exports of domestically produced goods, and more crucially to correct the balance of payments deficit. Moreover, other changes that were made also included several numerous incentives offered to MNCs to encourage FDI, lower tax rates, favourable exchange rate policy, liberal financial institutions and further privatisation of public sectors. During the same period, the government also decided to apply for structural adjustment loans from the IMF and the World Bank, provided that they complied with set of guidelines that were imposed on them. These conditions set out by the two institutions applied to a wide range of factors within the economy, for instance, trade reforms, financial policies, exchange rate regime and many other sectors.
In general, it can be argued that over the last few decades the rising challenges have made the economy more wary of where its main problems and challenges exist, and more crucially how they can go about improving these areas through policy changes. Moreover, trade liberalisation has also benefited the economy by encouraging international trade, which can be used to increase productivity and exports within domestic industries. However, the new trade policies have also had negative impacts on some sectors of the economy, which were unable to deal with the flow of foreign trade and increase in competition. Furthermore, while the main aims of the trade policies was to help achieve growth in domestic industries and foreign trade, other problems experienced by the economy such as high poverty and unemployment were still a major problem for the government. Despite some of the downturns, evidence from the last ten to fifteen years has shown that the overall performance and operations of domestic industries have taken a significant upturn. Moreover, towards the end of the 1990s through towards the new millennium, many of the major flaws shadowing the economy have been corrected. In addition, it can be strongly argued that the domestic economy is much more stabilised in comparison to the last few decades.
The Rationale for Trade and Development
This chapter examines some the general concepts of nations engaging in trade and development, and more crucially the outcomes derived from engaging in multilateral trade. The role of trade in economic development has been a significant factor for several developing nations including India. As reviewed in the previous sections of this report, the main emphasis placed on economic policies has largely been based on foreign and domestic trade. Moreover, trade amongst nations is broadly used for two purposes, which include gaining comparative advantage and secondly achieving greater economies of scale. The notion of comparative advantage was introduced by the famous economists David Ricardo, who stated that the productivity and resource levels varied amongst different nations. Furthermore, these differences in the availability of particular resources in one country gave it a comparative advantage over other countries. Hence, a country with comparative advantage of a good is able to improve productive efficiency within that industry and also increase exports to other nations that may rely on this particular commodity. Accordingly, countries who may not have access to particular resources may import them from other nations who have comparative advantage. In the case of India, the nation has a comparative advantage within the textiles industry. Whereas, some of the more developed western nations such as USA and EU countries have the advantage of vehicles technology intensive products. In general, the exports of goods from one economy and the imports of goods by another economy are usually referred to as inter-industry trade. Furthermore, the second main motive of trade is based on achieving economies of scale. The basic principle behind this concept is that, if a particular nation decides to expand the size of domestic industries and hence increase the size of production, it will be able to lower output cost per unit. Thus the nation will be to become more efficient and competitive, since it is able to manufacture products at relatively low costs. Moreover, an increase in efficiency within the industry also enables manufacturers to engage in product differentiation, which can increase the demand for the particular goods.
There are also some other benefits associated with trade amongst countries. One of the advantages of international trade is that it enables trading partners to have access to foreign resources and markets; hence it encourages a greater specialisation and division of labour. In addition, trade can also increase productivity of a country by improving the efficiency of resource allocation and therefore can boost the level of competitiveness of a country. Moreover, trade also has a considerable impact on the welfare and general living standards of people in developing nations, for instance in India the surge in foreign direct investment and transfer of new technology and training has improved labour standards substantially and consequently the average standard of living.
Nevertheless, there are also several main arguments made against the idea of international trade between nations. The crucial argument made by both developed and developing countries, places great emphasis on the fact that trade can have unfavourable effects on the domestic economy. For example, trade liberalisation would mean that established companies operating in developing countries can engage in off-shoring, since it is much cheaper to set up in less developed countries with relatively cheap labour. Therefore, many employees working in the home country will risk losing their jobs to foreign workers. Secondly, the rise in gap between low skilled labour and high skilled labour can also bring about inequalities in wages, since developing economies may not be able to compete with developed economies. Other disadvantages to international trade also include, for example, a country may be heavily dependent on foreign sources of supply for their inputs, which means that the performance of trade and output will be highly reliant on and foreign markets. Thus, if the price of raw materials increases or if there is a shortfall in the supply of the product, the importing country may encounter heavy losses and as a result can lead to a deficit. In addition, the performance of trade can also be affected by the colonial legacy experienced by most developing countries such as India, and therefore it take time for a government to establish new policies and reforms for its economy and political system, Shamsavari (2009). Overall, it can be argued that if trade had such negative impacts on domestic economies, the individual nations may choose to stop trading. However, on realistic terms the flow of trade between nations can balance out these problems, so that all countries can benefit.
Over the last two decades there has been swift transformation of the Indian economy through adopting trade liberalisation policies. Though the miracles did not happen overnight, the gradual progress of the new reforms over time has resulted in a success story for the country. This literature review is to provide a critical overview of the existing studies based on India's decision to liberalise trade, reduce import tariffs and the consequences on the performance of domestic firms and exports within the economy. The material which will be reviewed shall cover the various pieces of empirical and academic research conducted based on this topic, in order to interpret the results and main arguments that have been made. Thus, the methods and techniques used in each of the studies will produce a mixture in outcomes with regards to the implications of trade liberalisation and performance of domestic firms and general export levels. The crucial points of this literature review seem to indicate that trade liberalisation has its strengths and weaknesses on the domestic economy of India, and the statistical outcomes of each of the empirical studies seems to portray different results with regards to the performance of local firms and industry in general.
On the hand, research carried out by Nambiar, Mungekar and Tadas (1999) highlighted that since opening the domestic economy to foreign trade, the manufacturing industry has suffered a decline in production and employment. The report also raises awareness of the transition from high skilled jobs to low skilled jobs, which hinders the chances for local firms to become more established and competitive. Given the fact that the methods and techniques used by various researchers tend to differ, it will be interesting to assess the effectiveness of the techniques with regards to how they can be related to the volume of exports and the overall performance of local firms.
Introduction to trade liberalisation, import tariffs, domestic firms and exports.
Trade through imports and exports has long been a means of transfer of goods and services between nations across different continents, and has played a vital role in the economic development of many emerging economies that have engaged in such activity. In a broad context, trade liberalisation is usually the case whereby a country decides to engage in open trade and adopting some of the following measures, lower trade barriers, reduce quantitative restrictions, slashing tariffs rates, depreciating domestic currency and providing trade incentives. The trade liberalisation period of India was a major phenomenon that was considered as an option during the late 1980s and fully implemented in 1991. Having gained a brief insight into the implementation and development of trade liberalisation in India, we now look to examine some of the existing literature based on the new import liberalisation policies and the effects on the performance firms and exports of goods and services.
There is still a huge existing literature based on the debate of whether import liberalisation improves the performance of domestic firms or not. Many economists argue that the new policy reforms have had a positive impact on the growth and performance of firms in India. For example Unel (2003) conducted a study on the productivity trends of manufacturing firms in operating in India post 1990s. The empirical evidence indicated that when import liberalisation and the new policy reforms were introduced, the overall level of total productivity amongst the manufacturing sector had increased significantly. The wave of new economic policies signified the importance of benefiting both domestic industries and foreign multi-national companies. In addition, trade liberalisation policies also allowed most government owned firms to be privatised, and hence foreign multinational companies and new domestic firms were able to bring in new technology and sophisticated methods of production. In addition, there was also a surge in foreign direct investment (FDI), which domestic firms benefited from through spill-over effects, Shamsavari (2007). Furthermore, trade liberalisation led to the build up of a wide range of much needed resources that rural areas and most cities were previously unable to access. For example, the use of internet and enhanced telecommunications enabled firms to communicate better and hence improve productivity.
The dynamic effects of trade liberalisation. The arguments made for and against trade liberalisation.
Epifai (2003) examines the effects of trade liberalisation and the performance of local firms and labour markets in developing countries. One of the key findings of the empirical analysis indicates that trade liberalisation has not had a significant effect on the efficiency levels of firms. In fact the results indicated a negative correlation between the start of the trade liberalisation period and efficiency of domestic firms. Therefore, overall reduction in efficiency meant that firms operating in different industries were unable to improve their competitiveness and methods of operation, and hence were at disadvantage in comparison to their foreign competitors. Similarly, research based on the effects of trade liberalisation and the level of technical efficiency of domestic industries conducted by Parameswaran (2000), suggests that the level of technical efficiency decreased in post liberalisation era. However, one of the drawbacks of this report is that the empirical analysis was based on a sample of a few hundred firms that were selected; hence the results may not portray an accurate reflection of the improvements in technology amongst local firms operating in different industries. In addition, many studies still suggest that the trade liberalisation regime and other new reforms pursued by former finance minister Manmohan Singh and his cabinet members, have consequently led to a decline in the growth rate of productivity amongst firms. One of the main reasons for such outcome is described in a study by Epifai (2003), who highlights that the rules and regulations implemented within the domestic economy still remained an obstacle for local firms. Hence they were not able to fully benefit from the rapid changes in industry, which hampered the ability to improve productivity and performance levels.
In addition, Balakrishnan, Pushpangandan and Babu (2000), studied the effects of the new trade liberalisation reforms and total factor productivity of firms. The empirical analysis of the report covered 2,300 firms operating in five main industries, over a period of ten years between 1988 and 1998. Though the report covered a vast amount of domestic firms over a relatively long period of time, the outcomes of the econometric modelling suggest that there was no increase in the growth rate of productivity amongst these firms. Therefore it can be argued that although import liberalisation and the new reforms may have helped to tackle some macroeconomic problems faced by the Indian economy, the direct effects on firm productivity and performance seemed to be poor.
In conclusion to studying some of the reports that highlighted the negative relationship between liberalisation policies and the performance of firms, it is fair to say that most of data and methods used in the reports were fairly poor and unrepresentative of the economy as a whole. Thus, the following section looks at some studies that have demonstrated positive links between trade liberalisation and the performance of firms in various industries.
On the contrary, Chand and Sen (2002) also carry out an analysis on whether trade liberalisation has had an impact on the productivity levels manufacturing firms in India. The outcomes of the empirical analysis suggested that there was a positive correlation between the two variables. Though the study covered a vast majority of industries, the empirical analysis was based on data from 1973 to 1988 which implies that at the time a selective number of industries were still under the protection of the license raj. Furthermore, during this period import liberalisation had not been initiated and hence the performances of local firms were not fully portrayed. In theory some of the key benefits of trade liberalisation can be as follows; openness to trade can encourage more research and development amongst local industries and hence firms can become more competitive. In addition, trade liberalisation can also lead to the transfer of new technologies and knowledge through spill over effects and investment in capital made by local firms and multinational companies through FDI. As a result, local firms are encouraged to become more innovative and fewer dependants on the activities of more established firms, this also increases efficiency and the quality of goods and services produced by local firms.
Driffiled and Kambhampati (2003), examine whether trade liberalisation initiative has had a positive impact on the efficiency levels of domestic firms in India. The results suggest that, there has been a general improvement in the performance and efficiency of firms, which was largely dependent on trade liberalisation rather than imports in particular.
Goldar and Kumari (2003) study the relationship between import liberalisation and the effect it had on productivity growth of domestic firms. Carrying out an analysis of these two factors is very crucial when it comes to identifying the performance of firms post liberalisation. As indicated in previous studies based on the period when the Indian economy operated as closed economy with heavy restrictions against foreign trade, there was declining growth patterns and inefficiencies amongst firms. However, the outcomes of the research indicate that the eradication of these protective policies such as licensing requirements, had demonstrated a positive impact on the productivity of local firms. Nevertheless, it was also highlighted that the general increase in productivity growth had been weighed down by a lack of utilisation of industrial space, which ultimately led to a deceleration in total productivity growth within certain industries.
Vachani (1997) argued that pre liberalisation; India was operating in a closed market economy. Additionally, the government offered financial incentives to domestic firms in order to protect their markets from foreign competition. However, the trade liberalisation reform produced both advantages and disadvantages to firms. Ramachandra (1995) studies the impact of trade liberalisation reforms and the effects on the structure of the industry in India. The research was carried out based on a special case study of the petrochemicals industry, which is one of the biggest and high specialised industries within the economy. The outcomes of the econometric modelling suggest that trade liberalisation policies have led to an overall increase in the level of imports and exports for India; however statistics show that exports have been relatively more stable. In addition, the study highlights the fact that both GDP and imports have a imperative influence on each other, thus import liberalisation would have positive impacts on GDP and hence the performance of firms in general.
Mohanty (2003) carried out an assessment of trade liberalisation in India and its effects on trade relations with south Asian countries. The role of the South Asian Preferential Trade Agreement (SAPTA) was an agreement signed by several south Asian countries including India, in order to promote economic activity mainly through reductions in tariffs and liberalising almost all domestically produced products. Moreover, the project had proven to be successful for domestic firms in India, since it encouraged more joint ventures set up between home and foreign companies and enabled access to relatively cheaper sources of raw materials. In addition, tariff concessions and access to foreign resources have increased exports for India with bordering countries and on an international level. The ICRIER annual report (2008) highlights the fact that despite the existence of barriers on trade in the some sectors of industry, the overall performances of companies have shown a positive relationship with trade liberalisation. Moreover, the service sector has grown more significantly than all other sectors, and has been a major contributor to overall GDP. Hence, the main findings of the report seem to shed light on the hypothesis of this project, by demonstrating that in general local firms appear to have benefited from import liberalisation. Aghion et al (2006) highlight in their research that trade liberalisation had a more positive impact on the industries with relatively high employment rates, and consequently those working in rural areas tended to suffer. This demonstrates a bias with regards to the trade reforms, since they only seem to favour certain industrial sectors that may have relatively high skilled labour force and higher literacy rates in comparison to the majority of population who work in agricultural sector.
What is more, research conducted by Basu and Maertens (2007) raises similar concerns regarding the share of benefits received from trade liberalisation between main towns and cities and remaining rural areas. The results of the study suggest that there is a rising gap in the inequality between trade performance and growth of firms in main cities and rural towns and villages. Thus, this brings into question as to whether the new trade reforms have achieved their targets, with regards to improving productivity, efficiency and overall performance of firms operating in all sectors of the economy rather than just a few main industries. Rodrik and Subramanian (2004) examine several key factors of government policy that have led to a change in the transition and growth of the Indian economy. Their results seem to indicate that the dramatic upturn of the economy was largely due to a change in the mind-set and policies of the government, which had changed from a highly regulated closed economy to a more open economy with liberalised trade policies. In addition, the views expressed place great emphasis on the growth rates experienced during the 1980s in contrast to the liberalisation era post 1991. Moreover, the results from their study indicated that 1980s demonstrated better performance and growth rates than early 1990s.
The problems arising as a consequence of import liberalisation
One of the weaknesses of the trade liberalisation reforms has been that, there is an imbalance in the lack of attention and encouragement provided to domestic firms in comparison to foreign counterparts, Michael (1999). Therefore, this brings into question the effectiveness of these government led policies in context with the performance of local firms, and whether the domestic industries may be able to grow and become more competitive.
Moreover, during the last few years the Indian government has also initiated a number of lucrative incentives offered to transnational companies in an attempt to boost FDI, which without a doubt has proven to be a success. Some of these incentives included tax breaks, tax Holidays, duty free imports, designated Special Economic Zones (SEZs) and Export Promotion Zones (EPZs). Though it is argued that on the one hand FDI can benefit local firms through spill over effects, on the other hand these incentives have only seemed to be in favour of foreign firms, and there is still much debates regarding these incentives seeing as the local firms are being placed at a disadvantage within their home markets. However, these incentives have also helped increase exports levels, namely through SEZs and EPZs, which is also another benefit to local firms who may be involved supplying raw materials and other services used in the manufacturing process of these goods. In addition, along with trade liberalisation there was the transfer of technology which in general has played an influential role in the progress and growth of the majority of industries. However, there are two sides to the coin with regards to new technologies being transferred to India as a result of import liberalisation. For instance, the new technology only seemed to benefit particular industries in which large firms were financially well off and were able to import new machinery and hence improve productivity, competitiveness and overall performance. Nevertheless, most of the small and medium sized enterprises (SMEs) were unable to afford new equipment from abroad and consequently lost out in the chance of increasing their share of the market. Therefore it can be argued that, the role of technology on the performance of local firms has been like a game of catch up. Whereby, the big companies are able to make fast progress and increase global competition, where as less financially stable firms are left to develop their own methods and techniques for manufacturing which can be very time consuming and costly.
Katrak (2002), assess whether trade liberalisation hampers the ability and willingness of local firms to develop new technologies independently. This an important factor in context of the performance of local firms as it either help increase productivity and efficiency, or alternatively lead to greater exploitation towards foreign competition. Nevertheless, the main outcomes of the report suggest that, in general there has been an increase in the level of research and development and innovation of new technologies amongst the industries they studied. Hence, it can be argued that there is a positive correlation between trade liberalisation and the use of new technologies and methods of production amongst local firms. Moreover, even if some domestics are not able to develop or import new technologies due to financial constraints, they are still able to benefit through spill-over effects and hence improve their performance. In addition, Bishwanath Goldar (1990) carries out an assessment on whether import liberalisation helps to improve the efficiency of firms operating in different industries. The results for the econometric test indicated that, import liberalisation has a positive impact on the productivity and performance of domestic firms, since greater availability of resources through imports and increase in foreign competition seems to contributing factors. However, the study fails to take into account some of the problems that were experienced by the majority of rural sector industries, such as agriculture and farming. Moreover, research by Dhires Bhattacharya (1990) explains that import liberalisation cannot be the only factor that makes the new trade reforms successful and beneficial to the host economy. The author emphasis that there is greater need for the industrial mechanism to be more flexible, so that there would be less inefficiencies created amongst domestic industries. Based on these suggestions, one can still question the extent to which the government is able to deregulate the industrial structure, since it still has the responsibility for providing a degree of protection to its local industries. Kahthuria (2002), studies Indian manufacturing industries from the year 1990 till 1997. The aim of the research was to identify any patterns between trade liberalisation policies and the performance or domestic firms. The outcomes of the data empirical analysis, suggested that trade liberalisation reforms had helped to improve productivity only amongst technologically intensive and foreign owned firms. Hence, the remainder of industrial sectors that engaged in producing more general commodities were at a disadvantage. Kohli (2006), argues that the growth of domestic industries post 1991 was not due to the new trade liberalisation policies, but more related to the mentality and business drive of individual states towards trade.
In conclusion, there is a fair balance in the arguments presented within the literature that has been covered; hence it is not so easy to indentify particular results to be relatively more accurate and reflective of trade liberalisation and performance of local firms. Nevertheless, when India adopted new trade liberalisation policies, it was rather predictable that there would be some repercussions regarding domestic industry. However, in comparison to the economic situation of India pre liberalisation, it is fair to say that the new trade policies have benefited the domestic economy. The next Chapter will provide a review of the economic variables relating to the hypothesis.
Analysis of the Selected Economic Variables
This chapter of the report will present a series of graphs based on each of the selected variables used in the hypothesis. Moreover, detailed description of the trends in data series will be provided for the economic indicators, in order to provide a better glance of the affects of trade liberalisation on the domestic economy. Since the introduction of the trade liberalisation policies, there have been a number of changes in the pattern of production amongst domestic firms. The results of a study by Nambiar, Mungekar and Tadas (1999), seem to indicate that the majority of manufacturing has shifted from highly skilled to low skilled labour intensive jobs. Hence it can be argued, eradicating barriers to trade may have given multinational companies the chance to exploit the labour market and methods of production, therefore domestic firms may not be able achieve growth and improve their performance. On the contrary, the trade liberalisation reforms have also helped many sectors of the economy become specialised in their fields. For example, the Information and Communications Technology (ICT) sector has become one of the most advanced and specialised sectors in the world. Many of the major computer manufacturers have all set up Greenfield investments in this highly specialised industrial sector. In addition, the overall literacy levels for the majority of the states have increased, which implies that local firms have access to a more specialised market.
Graph 1: Trend in Exports for India during 1948-2008
Source: IMF World Data Statistics, for India 1948-2008
Based on the graph above, it is clearly evident that there overall export levels for India have been increasing. Export growth had been very much stable during late 1940s and mid 1970s; this was mainly due to the restrictive trade policies implemented on trade. Furthermore, from the 1980s onwards the trend in export growth had accelerated at a much greater pace than in previous years. The reason for this pattern was due to the fact that during the mid 1980s the first phase of liberalisation of the economy began, there was a general reduction in licensing laws and trade barriers. Moreover, during the early 1990s the export levels had almost remained constant; this was due to the hike in oil prices caused by the Gulf war. This also led to a trade e deficit for the Indian economy, therefore the government decided to significantly depreciate the currency in order to make exports more desirable to foreign markets. The pace in export picked up dramatically from the begging of the millennium, whereby total value of exports had risen roughly 5 million (US dollars) to almost 30 million in 2008. The main contributors to export growth where manufacturing industries and Information Technology (IT) sectors of the economy, since Indian had a comparative advantage in the textiles and computer software industries.
Graph 2: Trend in Imports and Exports for India during 1948-2008
Source: IMF World Data Statistics, for India 1948-2008
In relation to the the graph above, it can be observed that although there has been growth for both imports and exports, it seems that over time the sharp rise in domestic import levels have increased at greater rate relative to exports. Moreover, if the economy wishes to gain economic growth and become a key global exporter through the import liberalisation policies, it will need to focus on becoming a relatively big importer. The implication of such statement sheds light on the importance of new reforms such as lowering tariff barriers and abolishing licensing laws, in order to improve growth and performance of firms and ultimately exports. In addition, during recession in 1991 it can be observed that there was a slight contraction in the level of imports whilst export levels remained steady. Nevertheless, from the end of the 1990s till 2008 there has been a surge in imports, which could be due to the surge in FDI activities and the modernisation of domestic industries through imports of new capital.
Graph 3: Comparison of Tariff Rates with Imports and Exports for India during 1948-2008
Source: IMF World Data Statistics, for India 1988-2008, UNCTAD TRAINS, for India 1988-2008
It is quite evident that as tariff rates have been reduced each year, the level of domestic imports and exports have consequently been increaseing. This inverse relationship between the economic indiaciators is what would naturally be expected to happened, since lower tariff rates would been domestic firms are able to import goods from foriegn markets and hence increase production and export of domestically manufacutred goods. Moreover, low tariff barriers to trade also provides MNCs with the chance to invest in the host economy, and take advantage of lucrative trade policies.
Graph 4: Comparison of Tariff rates and Industrial Production for India during 1948-2008
Source: IMF World Data Statistics, for India 1988-2008, UNCTAD TRAINS, for India 1988-2008
The overall growth in industrial production has been increasing consecutively from 1998-2008. The effects of the trade liberalisation policies on industrial production post 1991, illustrated a steady rate for industrial production. However, from 1996 onwards there was a significant rise in industrial production, which shows an inverse relation with tariff rates. Thus, it can be stated that reduction in tariff rates has helped increase the production within manufacturing industries. Moreover, the trend in industrial production also implies that the demand for domestically manufactured goods services is increasing in both domestic and international markets.
11.1 Testing Hypothesis
Having covered a substantial amount of theoretical material based on import liberalisation and the effects on the performance of local firms and export levels. This section will be looking to test the main hypothesis of this report, based on the collection of relevant raw data and some econometric modelling. The four main variables that will be used in the empirical analysis will be Industrial Production, Imports, Real GDP and Tariff Rates. These variables will be based on a set of annual data ranging from 1988-2008, and the main aim is to find out the correlation between Industrial Production and tariff rates, exports and total GDP for the economy. In order to be able to perform these tests in an effective and accurate way, I will be using the Eviews statistical package in order to carry out a range of tests and provide detailed explanations. In addition, the data collected for each of the variables will be based on two widely used econometric models, firstly the Johansen and Juselious multivariate co-integration method and secondly the Vector Auto Regression model (VAR). The co-integration analysis will check to see if the data sets have any effects on each other, hence to identify any correlations. Secondly, the VAR model will give an account of the accuracy of the estimations made based on the hypothesis. Further explanation regarding the choice of these two methods will be provided within the discussion of the results.
Econometric Modelling: Cointegration and VAR models
The four selected variables that will be used in the econometric tests consist of one dependant variable and three independent variables. In this case the dependent variable is Industrial Production, and the independent variables are export level, tariff rates and real GDP. The basic principle behind this theory is to see, whether the three independent variables have any effect on the dependant variable. Moreover, these variables can be arranged into the following equation;
The log of Real Industrial Production calculated for the period 1988-2008 (t).
Is a constant.
= The log of Real Exports calculated for the period 1988-2008 (t).
= The log of Real Gross Domestic Product calculated at 1990 prices.
= The log of Real Tariff rates calculated for the period 1988-2008.
? = represents the error term.
Having defined the four economic indicators that will be used, the next step will be to create logs for each of these variables using the Eviews software. The reason for creating logarithms for each of the four data sets is to improve the precision and accuracy of capturing the gradual changes of the time series data. This is why both the dependant and independent variables illustrated in the equation above have the L symbol, which represents the logarithm. After the initial stage of uploading the raw data and creating logs, we perform the Augmented Dickey-Fuller (ADF) test in order to check for unit roots amongst the data sets. The purpose for carrying out unit root tests is to check if the set of data is stationary and more crucially to identify any patterns of co-integration between the variables. Alternatively, the unit root tests can also verify if the data used for each of the variables is spurious, which would mean that the figures are not useful for identifying patterns. Moreover, if we find that the data is not stationary, the order of integration can be applied using the ADF test in order to differentiate the data series a number of times to achieve stationary data. Hence, if the data set is integrated at order one I (1) demonstrate that the variable is stationary at the first difference. Additionally the data may be stationary at the integrated order two I (2), or sometimes at I (0) which means it does not need to be differentiated.
Results of ADF test
Having applied the ADF test to the selected data series, it is evident that the data does not seem to be stationary at I (0) or I (1), (Appendix A). However, when the data is integrated at order one I (2) the data is stationary and demonstrate co-integration, since the value of t-statistic is lower than the critical values hence we reject the null hypothesis, (Appendix A). Based on the ADF test, the r-squared values provides an explanation for the Cointegration of the dependant variable with regards to the independent variable. Moreover, the more closer the r-squared value is to 1, indicates a higher level of confidence between the data series. Thus, the r-squared value for ADF unit root test on the variables is 0.810145, which is significantly high and almost close to 1. This implies that the data variables are more likely to be cointegrated, since there is a high level confidence and stationarity between them. Another crucial indicator in the ADF test is the value of the F-Statistic, which helps to identify the extent to which the estimations made in the hypothesis regarding the variable are accurate. The value of the F-static for the selected variables is 1.600188.
Having carried out the ADF test, we find that the data is stationary and integrated at the second order difference, since there are no unit roots. In addition the r-squared value seems to give clear indications that the data variables are integrated at high confidence. The next step in the econometric modelling of the data series is to apply the Johansen and Juselious multivariate cointgration test, in order to see how well the independent variables are related to the dependant variable. Based on results of the cointegration test, (Appendix A), the r-squared value is 0.995684 which indicates that the there is cointegration within the variables. In addition, the following is the equation derived from the cointegration test, (Appendix A):
INDPROD = 22.7695018516*LIMPORTS + 17.7511310651*LRGDP + 0.199769944585*TARIFFRATES - 356.096941274
In conclusion to the data analysis, the test seems to indicate that the variables seem to be cointegrated. Therefore, the hypothesis based on whether import liberalisation hurts domestic industries and export levels, may not be true. However, the results of the analysis would have been more accurate if there was a wider availability of data.
The main objective of this dissertation was to investigate whether import liberalisation hurts domestic firms and export levels. The data analysis was based on four economic variables that were from 1988-2008. The econometric analysis also indicates that Industrial production is cointegrated with imports, real GDP. Hence a reduction in tariff rates has led to an increase in the industrial production and imports. In addition, the GDP rate for the economy has also been increasing. Moreover, it has become quite clear that pre-liberalisation the restricted trade policies adopted by the Indian government had led to decline in domestic manufacturing and growth of the economy. This is clearly evident in the graphs illustrated in chapter 12, where we can clearly identify no growth in exports corresponding to relatively high tariff rates. In addition, the level of imports and industrial production demonstrated very small signs in growth during the licensing period. Hence, it can be argued that the majority of domestic industries were not able to expand and become more productive, due to the restrictive licensing policies on local industries and high trade barriers. Up until the mid 1970s, the domestic firms continued to suffer from the unfeasible trade policies placed on them by the government. However, towards them mid 1980s onwards there was promising changes made to trade policies by the government, in order to achieve economic and enable domestic firms to become more productive and efficient. By 1991, almost all the restrictive policies had been either significantly reduced or abolished, and the Indian economy had officially become more open to trade. In addition, the effects of these changes are reflected in chapter twelve, as we can see a sharp rise in both imports and exports which lead to increase in overall industrial production.
With regards to some of the existing literature based on the topic of this project, it can be concluded that, the majority of researches have tended to express optimistic results with regards to trade liberalisation and the overall performance of firms and exports. Though many researchers still argue that although trade liberalisation has helped to speed up the growth in industrial development for the Indian economy, there are still gaps in the equal distribution of benefits shared between the different states. Hence, domestic firms operating in the states with favourable infrastructure and resources were able to improve productivity and their overall performance; however firms in other states may receive smaller benefits or none at all. Moreover, Agarwal (1994) draws comparison on liberalisation policies adopted by India and other developing nations, and concludes that although India demonstrated a positive response to the new reforms, nations such as China and Japan had been more successful in pursuing similar policies at a relatively faster pace. Hence this indicates that despite benefits of trade liberalisation on the domestic economy, there is still much room for improvement.
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