The Rise of the Indian Economy

The following text of a talk given by Professor Williamson at a conference for history teachers presents historical background and detail on the striking rise of certain sectors of the Indian economy. He discusses, as well, the prospects for the near future: Is a six percent growth rate, once considered by economists to be remarkably good, too high in this still generally poor land? — Ed.

by John Williamson

The rise of the Indian economy is one of the most important economic developments of our day. To put it in context, one needs to start by considering how India gained independence. The year was 1947, and it was the culmination of a long struggle between the British government and the Indian independence movement. That movement was led by Gandhi, but his most important lieutenant was Nehru. The two had very different views on a number of questions, and in particular on economic issues. Gandhi believed in a very simple life, while Nehru had absorbed the doctrines of British socialism. The British socialist movement at that time aimed to build up a modern economy as rapidly as possible.

THE POST-INDEPENDENCE YEARS
India in 1947 was characterized by very low per capita income. There were a lot of people, so there was always a big GDP, but per capita income was very low. In some ways India had a fully developed capitalist economy, and it had some of the oldest capitalist institutions in Asia, such as the Bombay Stock Exchange, founded in 1875. So there was a modern economy, but it was very thin. There was a manufacturing sector, but it didn’t cover many industries. There was even a steel industry and a relatively strong textile industry, but these were limited. It was predominantly a subsistence economy. Most of the villages at the time didn’t even have road connections. They were connected only by tracks to the outside world. They weren’t part of the market economy.

During the independence struggle in the final days of the war, Nehru was put in jail, along with a number of his Congress colleagues. In a matter of weeks, they drew up a
consensus which has been called subsequently the Indian Congress Consensus. At that time the Indian Congress absolutely dominated India, so what the Indian Congress thought went. There was certainly a widespread agreement on the need to develop, to create an industrial revolution, to grow rapidly, and to build a modern economy. This would involve moving agricultural workers to the cities, which it was argued-this was a popular line of thought in the early days of development economics-wouldn’t really cost anything, because the marginal products of those agricultural workers was negligible anyway. They really weren’t contributing in the countryside. In any event, with a little agricultural modernization, it would be possible to increase output.

It was generally agreed that society should be based on collective action, not capitalist acquisitiveness. Basically, the view was that the state ought to seize control of the economy and ought not be run by the capitalist sector. Consequently, for the best part of forty years after independence, growth was slow. But the “License Raj” developed very quickly. Everything needed permission. If you owned a business that officially was in the private sector, in order to expand you needed a license. You couldn’t get foreign exchange to import until you had the industrial license to expand. The government effectively controlled everything through a series of interlocking controls of that type.

sEven the banks were nationalized in due course. The banking system was one of the later things to be nationalized, in the late 1960s and early 1970s, but even then this philosophy prevailed. The system was dominated as in many developing countries by the idea of import substitution, the idea that you would get expanding markets for industrial goods essentially by producing at home things that had formerly been imported. That was because you simply couldn’t import most goods.

There was on the other hand continuous macroeconomic discipline. Unlike many developing countries in Latin America, or in Africa, or even in Southeast Asia (such as Indonesia), India never suffered from hyperinflation. India never went above about 20 percent a year. Instead, where the macroeconomic problems showed up was in balance-of-payment pressures. The fact that one required a license to import just about everything was strangling the economy.

DEVALUATION
Finally, in 1966, a year before the UK’s famous devaluation, came India’s. An attempt was made to undertake some liberalization of the economy at that time, and India sought U.S. aid. But since India wouldn’t support the Vietnam War, President Johnson withheld aid. So the envisaged flow of aid that would help make it possible to liberalize the economy wasn’t there, and India went back to slow growth for another 15-20 years.

Another feature of this period was that the educational system was very skewed. Illiteracy continued, and in particular female illiteracy, which is still quite common in India. But at the same time the elites have a very good educational system, typified by the Indian Institutes of Technology and Management, which were established in this period to cater to the elites. The education they received has been important in the subsequent development of the country’s economy. But in the early years, the economy grew rather slowly, at what became known as the Hindu rate of growth, merely 3-4 percent per year. At the time, the Indian population was growing at 2.5 percent per year. If GDP is only going up 3.5 percent a year, that doesn’t give much scope for an improvement in living standards and cutting poverty, the ultimate objectives of economic growth. In fact, there was actually an increase in poverty in India in the middle of that period. After reasonably respectable growth in the immediate post-independence years, by the early 1970s it had really slowed down to about 3 percent.

LIBERALIZATION
Then something changed. Initially we didn’t realize that it had changed. Dani Rodrik, a well-known growth economist at Harvard, and Arvind Subramanian, an Indian economist at the IMF, continuing a line of work pioneered by American economist Brad Delong, have argued that the acceleration in Indian growth really came long before 1991, which is from when reformers had liked to date it. They claim there is evidence that growth speeded up in the mid-1980s. However, up until then, you can explain away the faster growth rate as a consequence simply of catching up, because there was a severe recession in 1979, due to the second oil shock. In any event, by the mid-1990s one has indisputable evidence that the Indian economy had moved to a faster growth rate, following the first, limited reforms.

One example of liberalization was known as “broad-banding.” In the earlier period, if a private-sector entrepreneur was given permission to produce something, he produced exactly that and nothing else. Broad-banding meant that as long as he didn’t use more raw materials, he was entitled to make something else. What you were entitled to produce was broad-banded, or extended. And that in itself led to an important liberalization of the economy.

Another example is that the trucking industry was deregulated in the mid-1980s, which meant that people who owned trucks, still in the private sector, were allowed to go out to bid in order to take loads from one part of the country to another, at prices they could choose. This was successful in that trucking performance improved and prices were lowered as a result of competition, instead of going up, as those who had opposed liberalization had predicted. Toward the end of the 1980s, even though exports were growing rapidly, balance-of-payment pressures were beginning to rise and the budget deficit was increasing. These two things together led to an important crisis in 1991, at the time of the general election. Despite the debate as to whether there had already been some liberalization, 1991 marks the big liberalization of the Indian economy.

Manmohan Singh happened to be the finance minister at the time. When he was a young man at Cambridge in the 1950s, he’d written an article that argued that it was a mistake to rely on import substitution, but despite that he’d gone back to India, entered the civil service, and been a loyal civil servant implementing these sorts of policies all those years. But when he became finance minister and was presented with the challenge of finding a way out of the crisis, he set about undertaking a major liberalization of the economy. The macroeconomic part of the package was quite orthodox. After all, if you have a balance-of-payment crisis, if you run out of reserves, you have to fix the balance of payments in a hurry. You really can’t start revaluing the exchange rate or spending more, you have to do orthodox things like cutting expenditures, raising taxes, devaluing the exchange rate, and implementing monetary restriction.

The interesting part of the package was the microeconomic liberalization, which was adamantly against the Indian tradition. There’d been the very limited liberalization in the 1980s, but the main Indian ethos had remained very statist, hostile to the market economy, capitalism, and free enterprise. Singh swept away the controls of the license raj, the requirement that one obtain permission from the Capital Issues Committee to raise new money, and the ban on foreign direct investment. So investment was gradually liberalized, as was trade. The initial moves were to get rid of the quantitative trade restrictions. Tariffs were gradually reduced to the point of normal levels, though India’s still a fairly protectionist country. Then there was an effort to modernize the tax system. In 1991 about one-quarter of all the tax revenue came out of trade taxes, which would be lost with trade liberalization. Tax rates between one product and another were equalized, again gradually, over the course of the 1990s.

There was the beginning of divesting the public sector of its ownership of enterprises. India was not adventurous in this respect. It certainly didn’t do anything like the mass privatization in the former Soviet economies. It pursued disinvestment, which meant selling minority shares in enterprises on the stock market. You don’t pay a lot of money if all you think you’re going to buy is a minority share in a state-owned enterprise. This isn’t a good way of raising money or changing management incentives. So India was slow in divesting, but the program was started, and it’s gradually built up steam. There has been much more willingness to contemplate private enterprises competing against state-owned enterprises in recent years.

Finally, there was financial reform. Where India used to have one stock exchange, which still operated pretty much like in the nineteenth century, today it has a modern stock exchange running parallel to that one. The Capital Issues Committee was abolished, and companies were allowed to borrow freely. Where the banking system at one stage had to lend over 60 percent of its deposits to the government, and most of the others had to be lent as the government dictated, now it has a large degree of freedom to lend where commercial considerations dictate. Today India has a rather impressive financial system by developing-country standards.

CONSEQUENCES
Growth didn’t in fact accelerate much from the 1980s average to the 1990s average. But the 1980s ended in a crisis because some factors were clearly unsustainable, and although some of us worry about some features of the present economy, there’s no suggestion that the present growth rate is unsustainable. So it may have been only slightly faster, but it was sustainable. The growth translated into a fairly substantial fall in poverty over the course of the 1990s. The 1997 East Asian financial crisis really stopped growth in its tracks in many countries. Those countries, some of them more voluntarily than others, had all liberalized their capital accounts, allowing money to flow in and out fairly liberally. In contrast, in India, if you brought money in, you could take it out again, but domestic Indians weren’t allowed to take their money out freely, and India in any event hadn’t borrowed a great deal. So it wasn’t vulnerable to the 1997 crisis.

In the second half of the 1990s one also began seeing the rise of the IT sector. Two explanations are given for why that sector became so successful. The first is that the bureaucrats didn’t notice what was happening until it had already happened, so they couldn’t really interfere and put up a web of regulations and restrictions. That’s probably overly harsh. The other is that the government did some things right. Its founding of the Indian Institutes led to a flow of highly qualified manpower, many of whom found vocation in the IT sector. India at long last found its niche in the world economy, which wasn’t in exporting manufactures, like the East Asian countries, but instead was in the services sector, and IT in particular.

One important consequence of the 1990s is the sharpening of regional differences within India. The fast-growing states were in the south and west: Maharashtra, Haryana, Delhi, Gujarat, etc. The large states of the Ganghetic plain– Bihar, Uttar Pradesh, Madhya Pradesh, and Orissa–became relatively poorer during the 1990s. Policy, which became more attuned to rewarding success over the 1990s, may have exacerbated these regional differences.

Since there were a whole succession of governments over the 1990s, the Congress lost its monopoly as the party of government. There was a period when the regional parties were dominant in the mid 1990s, then the Bharatiya Janata Party (BJP) entered the government and early in this decade there were even several years when there was a solely BJP government. In Indian politics, there’s very little notion of economic ideology. The BJP tended to be a little more pro-market, a little less internationalist than the Congress, but the big difference is whether you’re in or out of government. Government will introduce something–to privatize the insurance industry, for example; MPs will vote in favor of it when they’re in government, and then three years later when the government has changed and they’re in opposition, everyone who previously voted in favor now votes against, and vice versa. So there’s no sort of socialist ideology in the way that there was in many European countries. All the governments of the 1990s were effectively reforming governments, even if not as strongly as some of us would have liked. They tried to push the reform agenda, and if they were slow, at least there were no big reversals as in Latin America and elsewhere.

INDIA TODAY
At the moment, the Congress-led government is in alliance with some of the regional parties. The BJP is out of government, having run an election campaign that was altogether too complacent last time around. Manmohan Singh is now prime minister, but Sonia Gandhi, who was born in Italy, leads the National Congress Party. To avoid the complications of having a foreigner be prime minister, she handed over running the government to Singh, who sits as a member of the upper house. The other key reformer is Palaniappan Chidambaram, the finance minister. He is a member of one of the smaller regional parties. While they haven’t been able to move as fast as they may have liked, they’ve unquestionably been moving in a reforming direction since coming into power two years ago.

Externally, there’s no hint of a balance-of-payments crisis. India has something like $130 billion of reserves. Indeed, there’s been some debate as to whether it couldn’t spend some of those reserves to advantage. There’s a sense of great optimism in India at last. It’s found its place in the world economy as the place to which the multinationals outsource jobs.

The debate is how much faster than 6 percent India should grow. When I was young we regarded 6 percent as a miracle. It’s what Italy did in the late 1950s and early 1960s, when we talked about the Italian miracle. Today, developing countries tend to regard 6 percent as the minimum. In India the debate is how much faster it should be able to grow. But there are still some big challenges.

First of all, there’s the fiscal deficit, which is around 8 percent of GNP and has been up toward 10 percent. Now India is growing faster than the U.S., so it can afford a deficit larger than the 3-4 percent U.S. deficit without debt’s getting out of control relative to GDP, but it still has one of the highest debt ratios in the world outside of Japan. It’s still a 90-100 percent debt to GDP ratio. Sixty percent is supposed to be the limit in Europe, by the Maastricht Treaty; the Latin Americans have decided that they really shouldn’t go that high, that 30-40 percent is the maximum prudent rate. And here’s India with 90+ percent and still rising. They haven’t had a crisis yet and seem confident that they’re not about to. They do have a high private- sector savings rate, which means that the debt is almost all held at home rather than abroad, which makes life simpler. But at some stage they’re going to have to get the deficit down. Otherwise, they’ll be spending their tax money on nothing but servicing the debt. There are some signs that they’re beginning to get a grip on this, but it’s still a major problem. As a Brookings Institution economist put it in the 1980s, “The fiscal deficit is not a case of the wolf at the door, it’s termites in the woodwork.” It diverts resources away from investment in productive activities into excessive spending by the government.

A second difficulty is one that it’s hard for people in most developed countries to believe is a real problem. But a large part of that deficit goes to financing the losses of the electric companies. Two and a half percent of GNP goes into power subsidies; only half the electricity that’s generated actually gets paid for. Some of the other half goes in unfortunate (we economists think) programs to give free power to the farmers. Unfortunately, the farmers who qualify for free power are the ones who are rich enough to be able to afford power in the first place. But having gotten free power, they let their neighbors tap into it. That’s another portion of the power goes that way. Then there are those who tap the lines. It’s dangerous, but people know how to do it. So half the power doesn’t get paid for even while there’s a big increase in the fiscal deficit, while one has very expensive power for those who do pay, which includes large industry. What do you do if you’re an industrialist with power that costs more to buy than you can generate it for? You buy a generator, which is socially wasteful. A lot of the investment in India is wasted by companies’ generating their own power so as to bypass the power system. So while there have been some attempts at privatizing the power sector and at imposing a regulatory system, there are still big problems at the moment.

Third, there is the social situation. Education is still a
problem in just the same way as it used to be. There’s excellent education for a small minority in the elite, and poor or no education at all for some people at the base of the pyramid, particularly women. India’s in the region where there are a hundred million missing women, as Amartya Sen wrote. Even if they get born, they don’t get educated properly. Malnutrition is another problem. About half of India’s pupils are malnourished. The problem is worse than even Subsaharan Africa. In all the other dimensions, India has now passed Subsaharan Africa easily, but in this one it’s still worse.

Finally, India is still a poor country. The average person still earns less than $2 a day. The figure is controversial, but the World Bank reckons that a quarter of the population are poor by its measure of $1/day in 1985 prices–that’s a destitution level, rather than a poverty level.

INDIA VS. CHINA
Which country is going to win this race? Most economists actually think it’s good when one country grows fast, that it helps another country grow faster. Nevertheless, there’s a big discussion as to which of these two will grow faster in the long term.

China starts off with a higher standard of living. It has more manufacturing, a bigger economy, much better infrastructure, and a dense network of superhighways, as against India, which is just finishing its first superhighway grid linking the four big cities, the ones with more than 10 million people. China also starts off with a faster growth rate. It’s been growing at 9-10 percent a year, it has a high rate–over 40 percent of GDP–of investment, it has practically universal literacy, and it has an open economy, measuring openness in terms of trade and FDI.

India has four major advantages. First, it is into the right things, the modern, skill-intensive service sectors like IT and outsourcing. Second, it has an entrepreneurial culture. Most Indians never fully subscribed to the non-acquisitiveness of the Congress consensus. Now that acquisitiveness has been given free rein, it’s producing a big advantage. Third is the fact that they have a much younger population, which means that their saving rate is going to increase in the future. A young population with a lot of people who are in the high savings phase of their life cycle is going to save more than an older population as it moves into the retirement phase and may stop active saving. Finally, in many ways India has better institutions. It has a tradition of setting up thoughtful committees before it makes a reform. It has a democratic system, which is a really major advantage. As countries modernize, one of the things people want is a greater say in running their own life. India already has that democracy, China doesn’t, and almost every country that’s made the transition has gone through a pretty traumatic process. Maybe China will be lucky, but India already has democratized and doesn’t face that risk. So for that reason the outlook is fairly good for India.

I see little reason so far to think that the Indian growth rate is currently above 6-7 percent on a trend basis, but that’s a lot higher than most countries have achieved for long periods of time. It’s high enough to take India into the first world in the course of some of our lifetimes. I don’t see this as a threat to the United States in any event. For all the jobs that are being outsourced to India, there’s some outsourcing in the opposite direction, opportunities that are only going to increase as India grows richer. So the outlook is basically optimistic. 

This talk was given as the keynote of “Teaching About India,” a two-day History Institute for Teachers seminar held March 11-12, 2006, sponsored by FPRI and co-sponsored by the University of Tennessee at Chattanooga and the University of Pennsylvania.

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Published by permission of the Foreign Policy Research Inst., Philadelphia, PA. See www.fpri.org. For further information, contact FPRI@fpri.org.