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 From the Wall Street Journal, July 14, 2005

(Also published in the Far Eastern Economic Review July/August 2005)

A Passage to Prosperity
Arvind Panagariya

Having sustained 6% annual growth since the late 1980s, India is now regarded as an unequivocal economic success. Prime Minister Manmohan Singh initiated many of the key economic reforms during his tenure as the finance minister in the ’90s. But his task remains incomplete. India continues to trail well behind China, which has been growing at the annual rate of 10% since 1981. From an equal level in 1980, per capita income in China today is more than twice India’s. The proportion of the population below the poverty line has dropped below 5% in China compared with 26% in India.

Though trade has grown rapidly in both countries, it has grown far more rapidly in China. Exports of goods and services grew at an annual rate of 15.2% compared with 10.7% in India. By 2003, China’s share of world exports hit a noticeable 5.8% while that of India remained virtually invisible at below 1%. Foreign direct investment in India expanded many-fold in the ’90s over the ’80s, but it remained less than one-tenth the level achieved by China.

The single most important factor explaining these differences is the relatively poor performance of Indian industry. Whereas the share of industry in China’s GDP rose from a high level of 42% in 1990 to 51% in 2000, it remained virtually stagnant in India. By contrast, the Indian service sector grew rapidly, expanding its share to 48% in 2000 from 41% in 1990. This trend has continued in the last five years.

Industrial output is far more tradable than services. True, information-technology services have a large traded component, but they are less than 2% of India’s GDP. Therefore a low share of industry and slow growth in IT translate into slow growth in trade. Moreover, in labor-abundant economies such as China and India, FDI is attracted principally to industry to take advantage of lower wages: A low share of industry means a lower level of FDI; and if the conditions for rapid industrial growth are lacking, growth in foreign investment will also be low.

What can India do to achieve the high level of growth and the low level of poverty achieved by China? Some argue that India need not follow the conventional growth path whereby the share of industry grows at the expense of agriculture in the early stages of development but yields to services in the later stages. According to this view, given its vast stock of skilled labor and lead in the information technology sector, it is natural for India to grow rapidly in services, skip industrialization, and leapfrog into the services stage. To put it dramatically, India need not become South Korea on the way to becoming the United States.

This is an enticing prospect, but the idea is hopelessly flawed. While the software and IT-enabled services have shown rapid growth in recent years, given their tiny share in the economy, they have made only a minuscule contribution to the growth of services.

Much of the growth has come from informal services where the wages and productivity are often low. The six largest service industries, accounting for 34.2 percentage points of the service sector’s 40.6% of GDP, are distribution services, public administration, real estate, community services, transport other than railways, and banking. Business services, which include software and IT-enabled services, accounted for only 0.3% of GDP, and communications services reached 2% of GDP in 2000.

Even if communications, software and IT-enabled services played a larger role, the idea that India can be transformed from a primarily rural and agricultural nation into a modern, urban economy without a substantial jump in industrial growth is a far-fetched one. Currently, nearly 60% of India’s workers earn their living from farming. While appropriate policies could help a large chunk of this population move into well-paid jobs in manufacturing, they cannot move off the land if job creation is concentrated in service industries like banking, insurance, finance, communications and information technology.

That’s because manufacturing only requires on-the-job training, whereas employment in the formal services requires at least college-level education. This means that a strategy that relies on services as the engine of growth must first educate the children on the farms so that they can find work when they become adults. Such a strategy cannot do much for the existing workers.

Therefore, the importance of the IT sector to the economy notwithstanding, the only way India can bring a large chunk of the farm population into gainful employment in a reasonably quick time is through faster expansion of the traditional, unskilled-labor-intensive industry. This suggests that the right strategy for India is to walk on two legs: traditional labor-intensive industry and modern IT. Both legs need strengthening through further reforms, and four specific reforms are of special importance.

• Under the Industrial Disputes Act enacted in 1982, firms that employ 100 or more workers in India cannot fire them under any circumstances. This law has understandably deterred multinationals as well as large domestic firms from entering labor-intensive manufacturing. For example, the apparel and toy firms in India remain minuscule relative to their Chinese counterparts. Given that workers may refuse to perform their normal duties in the absence of any fear of being laid off, Tyco can scarcely risk moving its toy manufacturing to India.

Large Indian firms have tried to escape the labor law by focusing on skilled-labor-intensive or capital-intensive sectors such as pharmaceuticals, IT, machine tools and auto parts, which principally employ white-collar workers who do not enjoy protection. Restoration of the firms’ right to fire workers in return for a reasonable severance is essential if India is to transform itself into a modern nation.

Defenders of the IDA argue that the main culprit for the poor performance of the labor-intensive sectors is the so-called small-scale industries reservation policy, under which most labor-intensive products such as apparel, footwear and toys have been traditionally reserved for the exclusive production of small enterprises. No doubt the SSI reservation has had a big impact in the past, but its removal will not be sufficient to bring large firms into the labor-intensive industries. This conclusion is supported by the fact that the relaxation of the reservation provisions for certain products has failed to generate significant entry.

• The fiscal deficit of more than 10% has starved industry of investment funds. Savings by households and corporations currently average 26% of GDP. After excluding household investment and retained earnings of corporations, financially intermediated savings are approximately 12% to 13% percent of GDP. Thus, the fiscal deficit absorbs virtually all financially intermediated savings. Foreign savings could fill some of the gap, but they translate into large current account deficits, which bring the risk of macroeconomic instability. Unless savings rise dramatically, bringing deficits down is essential to release investment funds to industry.

• Indian industry needs better infrastructure. To compete internationally, it needs reliable power supply at reasonable prices. Congestion at ports due to capacity constraints and poor administration hamper swift movement of goods. Airports in India are an embarrassment: A potential investor who takes a flight from New York to Shanghai and then to Delhi will think hard before choosing India over China. Finally, the movement of goods to and from ports requires the construction of reliable roads, a modern trucking industry, and the removal of restrictions on interstate movement of freight carriers.

• The most important potential bottleneck the Indian IT sector faces is the state of higher education. Currently, only 6% of Indians between 18 and 24 go to college. Of these, a tiny fraction has the skills necessary to perform tasks related to software and IT-enabled services. Unsurprisingly, competition for scarce skills has brought annual employee turnover rates in IT firms to more than 50% and a doubling of salaries for many in less than two years.

If the growth in the IT sector is to be sustained, India needs to fundamentally rethink its higher education policy. Given the fiscal deficits, the government has virtually no resources to expand and improve the education system. The proportion of GDP spent on higher education has progressively declined over the last several decades. And given the stringent fiscal constraints faced by the central and state governments, as reflected in their combined fiscal deficit in excess of 10% of GDP, the prospects for a rapid expansion of public investment in higher education are quite bleak.

To add to these woes, the existing universities in India are hopelessly ill-equipped to educate even those lucky enough to get into them. The physical infrastructure is crumbling. More importantly, professors are frequently absent from classes, “moonlighting” at private coaching institutes that prepare students to compete in various entrance examinations. If the universities manage to churn out some excellent talents, the credit goes largely to the brilliance and hard work of the elite students.

This leaves only two complementary options: the entry of private universities into the market and the introduction of tuition fees in public universities for those capable of paying.

The virtual ban on private universities in India is most puzzling. Many students would be willing to spend significant sums of money for a decent education, as shown by the expenditures they currently incur at U.S. universities. Given the high private returns to higher education, there is also a good case for the introduction of significant tuition fees in public universities to generate funds for the expansion and improvement of the quality of education.

Having got India on its feet in the ’90s, Mr. Singh must now push reforms further to ensure that it can walk briskly on two legs. He has a historic opportunity to build a modern India and he must not miss it.