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Rigid Labor Laws: a Minor Barrier to Growth?

Arvind Panagariya

            “Removing the main barriers to growth would free India’s economy to grow as fast as China’s, at 10% a year.”  This is the central conclusion of a recent report entitled “Achieving India’s Economic Growth Imperative” by the McKinsey Global Institute.

            The conclusion itself is not exceptional since many others, including the present author (Economic Times, January 12, 2000), have argued for some time that a double-digit growth is well within India’s grasp.  Indeed, Prime Minister Atal Bihari Vajpayee himself has mentioned 9 percent annual growth as necessary to double the country’s per-capita income in the next ten years.  What is exceptional about the report is the set of reforms it regards crucial to attaining the 10 percent growth rate and, even more importantly, the reforms it regards as not so crucial.

The report identifies three categories of reforms as crucial to pushing the growth rate to 10 percent: removal of a set of product market regulations, elimination of land-market distortions and privatization.  Simultaneously, it considers the reform of inflexible labor laws and poor transport infrastructure as not so crucial, arguing that this reform will contribute only half percent to GDP growth.  The report concludes that it will be a mistake to focus reforms on these areas at the expense of the three categories of reforms viewed as crucial.

Few would disagree on the importance of speeding up privatization and removal of product market regulations such as small-scale reservation.  The report is also to be applauded for bringing to the center stage land-market distortions, which have received less than their fair share of attention in the debate on reforms.  Nevertheless, the conclusion that rigid labor laws constitute a minor barrier to growth reflects poor judgment.

Thus, consider the evidence contained in the report itself.  In its careful case study of the apparel industry, the report argues that a key factor inhibiting productivity growth is its small scale and current organization.  In Sri Lanka and China, apparel factories have thousands of workers under a single roof.  In India, on average, tailoring shops employ 3 to 4 sewing machine operators, manufacturers selling in the domestic market employ 20 workers and those selling in export markets 50 workers.  The report identifies the switch from tailors to large-scale manufactures as the greatest source of productivity gain.

But how is this transition to take place?  The report assumes that the current small size of manufacturers is due to the small-scale reservation.  If so, the recent announcement of the withdrawal of this reservation should pave the way for China-like large-scale manufacturers.  But this is wishful thinking.  For several years now, exporters, defined as those selling 50 percent or more of their output abroad, have been free of the small-scale regulation.  Yet they have opted to enter on a scale far below that prevailing in the Chinese factories.  Few investors are willing to be left stranded with thousands of workers in a manufacturing world that has no exit doors.  Contract workers allow investors to get around labor laws but it is a prohibitively costly activity when the number of workers runs into thousands.

Indeed, we grossly underestimate the cost of rigid labor laws when we limit our calculations to the costs incurred by existing entrepreneurs.  Since the existing industry itself is small relative to its potential size, true costs are many times those borne by the existing entrepreneurs.  For example, we must ask how much larger would our apparel industry have been in the absence of the rigid labor laws.  Will even a privatized Air India operate at the efficiency of the Singapore Air if the current labor laws continue to govern its operations?  Why is it that the service in even private sector Indian banks is so poor?  Why are foreign banks, which offer better service, afraid to expand their operations beyond high-end customers?  Will we fully reap the benefits of private entry into the insurance sector under current labor laws?  Are auto manufacturers not choosing to operate on a relatively small scale thereby sacrificing the option to export due to costly exit in the event of a failure?

This quibble on the importance of labor law reforms notwithstanding, however, the McKinsey report offers a wealth of information and analysis in its in-depth studies of 13 major sectors: two in agriculture, five in manufacturing and six in services.  One sector that has been generally neglected by the current policy debate and is emphasized in the report is retail.  The report argues that allowing foreign supermarket-style retailers into the market could lead to dramatic gains.  Citing the experience of Thailand, People’s Republic of China, Brazil and Poland, it points out that foreign retailers can bring global best practices in retailing to the country and also lead to productivity gains in wholesaling, food processing and consumer goods manufacturing.  These are interesting ideas that deserve further study and analysis.

The case study of apparel industry suggests that unless we undertake massive internal reform and reorganization, we may not be able to reap full benefits of the scheduled end to MFA quotas in developed countries on January 1, 2005.  The report makes the case that the current poor performance of the industry in export markets is due to inefficiency rather than quotas.  It notes that India’s share in apparel imports of top 10 non-quota countries at 1.6 percent is less than its share of 3.2 percent in top ten quota countries.  The reverse holds true for the more competitive People’s Republic of China: its share in apparel imports of top ten non-quota countries is 38.1 percent and that of top ten quota countries is 11.3 percent.  Thus, India faces a formidable competitor in the future, quota-free world.  The need for the end to small-scale reservation and introduction of flexible labor laws that will permit the industry to reorganize and become competitive is nothing short of urgent.

Economic Times, September 26 2001