India’s Growing Economy: Song of the Crossroads

February 18, 2008

Until as recently as 1990, India was essentially insulated from the world markets. With foreign trade and foreign investment amounting to a tiny proportion of the GDP, ups and downs in the world economy mattered little. Movements in the Indian economy were even less consequential for the world economy — India accounted for negligible proportions of world trade and investment.

But the reforms undertaken during the last two decades have dramatically transformed the policy regime with the result that the fate of the Indian economy is now intimately linked to that of the world economy. In the reverse, the world economy has also come to depend on the Indian economy, though to a lesser extent. This is because India is still small relative to the world. But this too is changing rapidly.

To grasp the transformation that has taken place, consider just a few facts:

  • Trade in goods and services as a proportion of the GDP has risen from 16 per cent in 1990-91 to 49 per cent in 2006-07.
  • Direct foreign investment has risen from less than $100 million in 1990-91 to $19.5 billion 2006-07. Alongside, portfolio investment has risen from $ 6 million in 1990-91 to $7 billion in 2006-07.
  • Remittances have risen from $2 billion in 1990-91 to $28 billion in 2006-07.
  • Acquisitions by Indian companies abroad, which have included such steel giants as Arcelor and Corus, amounted to almost $35 billion last year.
  • India grew 13 per cent per annum in real dollars during the four-year period spanning 2003-04 to 2006-07. If this rate is maintained and the US economy grows at 3 per cent per annum, India will become two-fifths of the US economy in just two decades.

These statistics testify to the rapidly growing importance of the world economy to India and vice-versa. They also bring into question the complacency on the part of many that India remains immune to the events in the world economy. Those arguing that China is far more dependent on the world economy, especially the US, are technically correct but underestimate its importance for India. The US remains by far the largest export destination of Indian goods. Therefore, a slowdown in the US economy is bound to have an adverse impact on India’s exports. Equally, a slowdown in the Chinese economy induced by the slowdown in the US will have an adverse second-round effect on Indian exports since China too has emerged as a major and fastest growing market for Indian goods.

What should be India’s response to the possibility that the slowdown in the world economy may cost it 1 percentage point or so in growth? There is a great temptation to argue that a decline in the growth rate from 9.5 per cent to 8.5 per cent is not a catastrophe so that we can go about business as usual. But that will be a mistake. Our objective has to be to accelerate growth to the 10-11 per cent range to further speed up the elimination of poverty. And that calls for acceleration of reforms that have been behind the current surge in growth.

One reform on which the Finance Minister has already delivered and for which he must be applauded is further trimming of the small-scale industries (SSI) reservation list. On February 8, he de-reserved another 79 items leaving 35 items on the list. The de-reservation is bound to pave the way for the expansion of efficient firms in these sectors, turning some of them into successful exporters.

One further area in which the Finance Minister has continued to move forward is the trimming of the top industrial tariff. Last year, he brought this rate down to 10 per cent from 12 per cent. He must continue this process bringing the rate down by 2-5 percentage points. With the recent appreciation of the rupee, pressure has built up against further trade liberalisation. But bowing to this pressure will be a mistake: trade liberalisation must continue with rupee depreciation providing the short-run cover against import surges. The Finance Minister has a unique opportunity to finally deliver on the promise, made in the 1997-98 budget and earlier, to bring industrial tariffs down to the Asean (Association of Southeast Asian Nations) levels.

The UPA government is, of course, pre-committed not to undertake some of the most important labour-market reforms. So calling for it is fruitless at this juncture. But one extremely important non-controversial area with an unusually high payoff is the building of all-weather rural roads connecting villages to the mainstream economy, thus, enabling rural folks to convert their entrepreneurial talents into effective incomes. It is an embarrassment for a nation that has now learnt to build world-class national highways — you only need to drive on the six-lane Jaipur-Kishangarh highway or the recently built Gurgaon-Delhi highway to be convinced — to utterly fail in the delivery of reliable rural roads.

The failure is to be squarely traced to policy. Unlike national highways, rural roads are contracted out to small entrepreneurs via projects ranging from 10 to 50 million rupees. These small entrepreneurs have little experience building all-weather roads. Simultaneously, the government lacks resources to monitor a large number of small entrepreneurs. What the government needs to do is to bundle these tiny projects into a large project making it attractive to the firms engaged in building national highways. On the one hand, these firms are better equipped to build all-weather roads and, on the other, the government can monitor them more closely if it has to monitor only a handful of them.

Other non-controversial areas of reform are agriculture and electricity, both of which fall under the jurisdiction of the states. Here some officials argue that the central government can induce reforms only through conditionality whereby it makes the availability of funds to the states conditional on reforms. But this becomes politically difficult when it comes to poor states — how can the central government deny assistance to the poor?

Once again, this line of defence begs the question why the government mixes up its assistance to the poor with instruments to affect reforms? What it must do is to decouple its assistance to the poor from other expenditures. Assistance to the poor must be given through direct, unconditional transfers rather than regressive subsidies such as those in fertiliser, food procurement, electricity and water (who but large farmers can reap these subsidies in large chunks?). Once this is done, disbursement of other funds can be made conditional on reforms in areas such as electricity and agriculture without the risk that the denial of such funds will be seen as anti-poor.

In concluding, let me note that India has been growing 8-9 per cent per year even in the presence of very large inefficiencies. This is a reason for great optimism. If we can keep clearing the sources of inefficiency as we have done to-date, pushing the growth rate to the 10-11 per cent range is entirely feasible.