(As prepared)
I first came to India in 1967 as the junior economist on a World Bank team. I then spent three and half years in the Bank’s New Delhi office reporting on India’s economy.
Contrary to the popular view at the time, not all World Bank economists were devotees of Milton Friedman and market economics. From my economics training in the UK and the US, I had concluded that reliance on the market was unlikely to produce the rapid development that poor countries like India aspired to.
Instead, state intervention would have to be the driving force: taking ownership of the key industries; directing investment and production in the private sector; strict controls on imports with the aim of self-sufficiency wherever technically possible; and eschewing inward investment so as to reduce the dependence on foreign capital. I was impressed by the planning models used by the socialist countries and by the rapid growth they had apparently managed to achieve.
India’s economic strategy in the 1950s and 1960s was precisely on these lines. It was a shock therefore for me to discover when I had spent a little time here that it wasn’t working. Economic growth was a stuck at around 3 percent; basic services like health and education were lagging far behind political aspirations; and the number of very poor was steadily increasing.
For a while I this put this down to unfavourable factors outside India’s control – the failure of successive monsoons, the failure of the aid donors to deliver on their promises, and the 1971 Indo-Pak war. But I then realised that the real problem was less the imperfections of the market and more the imperfections of government and of government policy.
The throttling of private sector initiative and the almost infinite protection of what private sector activity existed; the repression of the financial sector; the attempt to insulate India from the international economy; and the huge waste in the public sector – these were all doing a lot more to damage India’s development than whatever failings existed in the domestic or international market-place.
Along with most economists in India, I was slow to learn that without a sea-change to a more market-oriented set of policies, India was likely to be stuck with low growth.[1]
The real turning point, as everyone knows, was 1991. From then onwards, the panoply of controls – on domestic and inward investment, on imports, on prices, on the financial sector – was gradually eased. Sky-high tariffs were substantially reduced and, after decades of economic autarchy, India at last started to become a serious participant in the global economy. The response was positive as economic growth quickly moved onto a higher trajectory.
For a while in the late 1990s and early 2000s, it looked as if the upward trajectory might have stalled. But this proved only a temporary blip, and the growth rate achieved in the last three years – about 9 percent per year on average – has been simply stunning.
Right across the board, performance has been impressive.
Until quite recently, price inflation has held steady at around 5 percent. Domestic savings and investment have jumped dramatically.[2] The balance of payments is strong, with reserves now exceeding $300 billion. The back-log of investment and inefficiencies in infrastructure are at last being seriously addressed, helped by private partners in several areas such as ports, airports and roads. Foreign direct inward investment, though still small by China’s standards, has increased to about 2 percent of GDP in the last two years.
The publicly owned banks are no longer mere agents of government and, though they have a long way to go in terms of efficiency, are now operating more or less commercially. The securities markets now match the best in Asia in terms of cost and efficiency. The combined fiscal deficit of central and state governments has come down from a worryingly high 9.5 percent of GDP in 2002/03 to a more manageable 5.5 percent in the current fiscal year. The incidence of dire poverty, if not yet the absolute number of the very poor, has fallen very considerably.[3]
The most spectacular growth has of been in the services sector, especially software and IT enabled services. Manufacturing growth has picked up in the last year or two, with growing evidence of Indian competitiveness in products such as pharmaceuticals and engineering with a high technology and design content. Yet going back ten to fifteen years, manufacturing has lagged well behind services.
In this respect, therefore, the pattern of India’s take-off has been rather different from that of other countries.
Other large countries such as China and Indonesia have secured their productivity gains by the transfer of labour from low productivity agriculture to high productivity manufacturing. By contrast, India appears to have achieved the productivity gain by leap-frogging from agriculture to services. Manufacturing output and exports remain relatively small in relation to GDP. Employment in the high productivity “organized” manufacturing sector has actually been on the decline.
The “organized” manufacturing sector has been held back by a number of factors: continuing reservation of certain products for the Small Scale Industry (SSI) sector; lack of decent infrastructure; continuing red-tape; burdensome labour laws affecting larger businesses which have discouraged smaller businesses from expanding and have encouraged labour saving investment in preference to labour recruitment.
The expansion of the software and IT enabled services has produced fabulous productivity gains for those employed in it, but they only comprise about 1 million workers. There has to be a worry is that without a faster expansion of manufacturing, India won’t be able to achieve the necessary expansion of high productivity employment and thereby achieve more evenly spread growth.
This leads immediately to the question: can India maintain a 9 percent growth rate?
Anything less than this would probably mean rising unemployment or under-employment. According to the official statistics, India has been producing ten million new jobs a year but it needs even more if unemployment isn’t going to rise. This is the down-side of the so-called “demographic dividend” which is fine provided there are enough jobs but a burden if there are not.[4]
Unless the economy gets thrown off course by external factors or by a serious set-back on the domestic front, 9 percent growth over the medium term would seem to be quite plausible. With average productivity only about 10 percent of that in the US, the potential for further catch-up remains large.
The OECD in its 2007 Survey of India outlined two scenarios – first, a status quo scenario with output growing at 8 ½ percent per annum; and a second, more optimistic scenario with output growing by over 9 ½ percent, dependent on further fiscal consolidation and further significant reforms to help boost the private sector.
Unfortunately, the current global economic turbulence must pose a risk to both of these scenarios.
India has benefited hugely from opening up its economy, but now its greater openness makes it more vulnerable to external events. Until a few months ago, there was a fairly widely held view that India and China could ride out the storm with much damage. This no longer seems to be correct.
India is still a relatively closed economy when compared with China and other East Asian countries. So to that extent, it is less exposed to any slowing of growth overseas. The main concern must be exports of software and IT enabled services, which could be badly affected if the US does go into recession. On the other hand, the sector might benefit if tight budgets in the US lead to even more out-sourcing.[5]
India’s financial sector has relatively little direct exposure to sub-prime lending.[6] Yet Indian businesses are likely to find it more difficult to borrow from international banks operating in India, and there now appears to be some contagion from overseas affecting the willingness of Indian banks to lend.
Commodity prices are another problem. Higher petroleum, edible oil and grain prices are feeding into inflation which has picked up quite considerably in the past couple of months and is now well above the Reserve Bank of India’s 5 percent target. This is now leading to some tightening by the Reserve Bank of India of its credit policy, and higher inflation is likely to make consumers more cautious.
A further and final impact from overseas has been the appreciation of the rupee. India has been attracting a lot of short term money – in itself a mark of overseas confidence in the government’s policies. But this poses a threat to India’s competitiveness. Equally, it poses a threat in a downward direction if there were to be a sudden turn of sentiment. On both these counts, India has been wise in my view to go slow on capital account rupee convertibility.
All these external factors point to a possible slowing of growth in the short term.
The other main risk is that policy reform and further improvements to the business environment might come to a halt, or even – in the run-up to the 2009 elections – go into reverse. My own view is that the latter is unlikely, but it cannot altogether be ruled out.
If I were an Indian policy-maker, I would be tempted to sit back after the achievement of the last few years. But this, it seems to me, would be a false temptation. It would be too easy through fiscal neglect or a failure to tackle the remaining supply-side obstacles for economic growth to slip back. India’s policy makers, I think, fully recognize this. The worsening international environment gives the continuation, and preferably the deepening, of reform added urgency.
But I fully realize that saying this is easier than doing it. The politics of economic reform in India are clearly very complex – and not well understood abroad. The contrast with Thatcher’s economic reforms seems quite striking. Lady Thatcher was a leader who pushed through her reforms in a very up-front manner, taking advantage of a widespread view in the country that the previous interventionist policies of Labour had failed.
In India, despite the economic crisis of 1991 and a growing acceptance that the old economic model hadn’t worked, the political appetite for reform seems to have been much more ambivalent. Liberalisation seems to have pushed through in the 1990s almost by stealth, made possible as some have argued by the distraction of reservation and caste (Mandal-Mandir) politics.[7] While Thatcher presented her policies as a dramatic break with the past, the Rao government presented their reforms as continuity and almost “business as usual”.
And even today, when India’s economy has really taken off, government has to tread carefully. People overseas tend to forget that the biggest winners in the 2004 elections were the leftist parties who are now influential players in the coalition government at the centre.
Against this background, one is loath to offer suggestions on priorities.
But I would suggest five - in no particular order.
The first is to ensure that the combined centre and states fiscal deficit is contained at no more than the current 5 to 6 percent of GDP. Preferably, this should be further reduced and, in addition, the combined revenue deficit needs to be converted to a surplus so that the public sector is providing at least some of the savings to support public investment. As part of this, loss-making public sector businesses need to be subjected to market disciplines or privatised.
Secondly, investment in infrastructure has to be increased further (it has been growing at only half the rate of growth of GDP), and existing assets such as rail (where productivity is half that of China), airport and electricity networks should be made more efficient - if infrastructure is not to hold back investment and output in other sectors, particularly manufacturing. Given the lack of savings in the public sector, this will require a bigger contribution from the private sector. The Viability Gap Fund created by government seems to be an effective way of helping the private sector to get more involved.
Thirdly, in order to help raise the level of investment in all sectors and to enable India to further develop its international competitiveness, the remaining restrictions on inward investment need to be further liberalised.
Fourthly, further action is needed to free up the regulatory regime which continues to be a serious constraint for some investors, both foreign and domestic. According to the OECD, the business climate is ranked only 134th out of 175 countries, and much of this is down to regulation and red-tape.
This is not to deny that there are on-going efforts in this area, such as the welcome phasing out by 2009 of the reservation of a number of industries for the small scale sector. The much lighter level of regulation applicable to the now numerous Special Economic Zones, and their success, shows what can be done. Sectors where government regulation has been eased (eg communications, insurance and IT) have grown more rapidly than others.
The most pressing need in the regulatory area is amendment of the provision in the Industrial Disputes Act which requires companies employing more than 50 people to obtain the permission of government before they make anyone redundant. Judging from the Economic Survey which accompanied the recent central government budget, this appears to be off-limits politically. Yet apart from the problem of infrastructure, this more than anything else seems to be holding back industrial expansion.
There is no doubting the political problem of moving on this particular front (or in another related area - making it easier for failing firms to exit). But - for what it is worth - the reform of Britain’s labour laws was the most challenging thing politically that Mrs Thatcher undertook. The vested interests of a minority of workers were threatened, just like in India today, whilst it seemed clear that liberalisation would benefit the majority. That is how it turned out, and in retrospect, these reforms were in my view the most important of the Thatcher period.
Fifthly and finally, governments at the centre and state level have to become more effective, efficient and transparent, and the rule of law strengthened. Historically, these have all weighed in favour of India compared with many other countries. But there is much to be done, for example in making public spending in health and education more productive, speeding up government administration, and tackling the problem of corruption.[8] (The latter is not as bad as in China, Indonesia or Russia but that is not saying a great deal).
As Montek Ahluwalia has written, “economists probably focus too much on the role of policies, and tend to under-play the importance of institutions”.[9] I am sure he is right. India is much more likely to go on growing at near double digits if governance issues such as these are successfully tackled.
Economists are well known for spreading gloom. That has not been my intention – which has been to point out the principal downside risks to India’s 9 percent growth ambition. And It is hard to discern any upside.
Fundamentally, nonetheless, I am on optimist on India. And certainly there is no country, given her commitment to democratic rule and the size and complexity of her problems, that more greatly deserves to succeed.
[1] There were notable exceptions amongst Indian economists, such as Jagdish Baghwati and T.N. Srinivasan. And at the World Bank there had been a consensus since the mid-1960s amongst most of its economists who worked on India that a move to more market oriented policies was necessary - see the 1965 report of the Bell Mission.
[2] Part of the increase in savings may be due to better recording as the economy has become more monetised.
[3] See OECD Economic Survey of India, 2007, for a comprehensive analysis of recent trends and prospects. Also the Economic Survey accompanying the Government of India Budget for 2008/09.
[4] It seems ironic that in the 1960s and 1970s, we were all concerned about population growing too fast; but that was when India seemed stuck on a low growth path.
[5] In 2004, as a share of the nation’s valued added, communications and computer services represented 3.9 percent and 2.5 percent respectively (up from 1.7 percent and 1.0 percent in 1999). In the period 2000 to 2004 these sub-sectors grew by 24.9 percent and 26.9 percent annually on average. Sales of computer programming services, software and other IT technology related services made up 27 percent of Indian exports in 2005, up from 2 percent in 1995. During this same period exports of goods and services as a percentage of GDP increased from 10 to 20 percent. All these figures are taken from the OECD Survey referred to earlier.
[6] India’s largest private bank (ICICI) has recently announced sub-prime losses of $264 million, but the public sector banks have steered clear of these assets.
[7] See Maria Misra, “Vishnu’s Crowded Temple – India since the Great Rebellion”, Allen Lane, 2007 – see pages 297 and 490-491.
[8] According to the World Governance Indicators produced by the World Bank Institute, India was ranked at the 53 percentile amongst all countries for the control of corruption. According to these Indicators, India improved its ranking from 40 percent in 1996.
[9] Chapter in “India’s Economy – a Journey in Time and Space”, eds. Raj Kapila and Uma Kapila, Academic Foundation, New Delhi, 2006.
