Trade Liberalization, Fiscal Adjustment, and Exchange Rate Policy in India

Abstract

The authors investigate the impact of India's program of economic stabilization and trade liberalization launched in 1991, a year when the country was in the throes of a foreign exchange crisis. The authors address a key policy tradeoff between trade liberalization and fiscal adjustment arising from India's heavy dependence on tariffs for public revenues. They give quantitative expression to how trade liberalization should be coordinated both with fiscal adjustment - that is, a combination of trade-neutral tax increases and expenditure reduction and with a policy of exchange rate changes to restore both internal and external equilibrium. This paper asks: What is the impact of a reduction in the fiscal deficit characteristic of stabilization programs on tax and expenditure levels, on the real exchange rate, and the current account deficit? What is the effect of a significant trade liberalization without additional external financing on macroeconomic variables such as the required degree of fiscal adjustment and change in the real exchange rate, and, at a more disaggregated level, on output levels in different export-oriented and import-substituting sectors of the economy? What would the impact of such trade liberalization look like should substantive external financing become available without the need for domestic fiscal adjustment? The questions are explored using a general equilibrium model of the Indian economy that focuses on the consequences of trade policy reform. Policymakers are, however, also interested in how various import-substituting industries would be adversely affected by trade liberalization and how particular export-oriented industries would gain from it. These objectives are reconciled by the innovative expedient of implementing two models on a common data base: 1) a disaggregated 72-sector (price sensitive) input-output version that makes simplified assumptions regarding certain economywide relationships; and 2) an aggregated 6-sector version that pays attention to those relationships and can suggest what corrections ought to be made to the results of the sectorally disaggregated analysis. The policy questions were answered for the eve of the 1991 economic reform program launched by India's policymakers. Developments in the principal macroeconomic aggregates in the first two years of the liberalization process were then compared with the outcomes of the model and generally found to correspond closely. This finding encouraged an updating of the model for fiscal 1992-93 and its deployment to analyze the consequences of a set of further economic reforms for subsequent years. The authors conclude by suggesting that the approach developed for this paper could provide broad indications of the economywide and sectoral consequences of pursuing the unfinished agenda of reforms facing policymakers not only in India but in other developing countries as well.