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Is the Indian miracle inevitable?

ARVIND PANAGARIYA

There is a sudden optimism bordering on euphoria that India is poised to match, even beat the Chinese miracle. Pundits are betting that the decline in the interest rates, the expected rise in the proportion of the young in the total population, and the existence of homegrown multinationals guarantee a rapid transformation of India into a modern economy.

Is this healthy optimism or wishful thinking? I have argued for some time now that a double-digit growth rate necessary to achieve the rapid transformation is well within India ’s reach. Yet, without some key reforms on which we have been dragging our feet for some time, such transformation is a pipedream. Rapid transformation requires massive movement of the labour force out of agriculture, which requires a double-digit growth of traditional industry, and hence reforms.

Today, 65% of India ’s labour force is in agriculture in comparison to China ’s 25%. Industrial output in India accounts for 27% of GDP compared to almost 50% in China . Only rapid industrial growth that pulls labour from underemployment in agriculture into high productivity jobs in industry can yield the speedy transition we seek.

Some argue that services, especially those in the information technology (IT) sector including outsourcing activities, can accomplish for India today what manufacturing did for the economies of East and Southeast Asia yesterday. We could turn into the global hub of back office services the same way that East and Southeast Asia became the global hub of manufacturing a decade or two ago.

There is no doubt that we must exploit our comparative advantage in the IT sector both at the low and high ends of the spectrum. Yet, we must recognise that this sector by itself cannot rapidly absorb a large proportion of the vast agricultural labour force. Currently, the sector employs less than a million workers. Therefore, its capacity to absorb labour in the medium term is limited even if it grows at astronomical rates. Moreover, to bring workers into this sector, they must first be taken through high school and perhaps a few years of college education. This takes time. And with only 6 to 7% of the college-age population attending college currently, our capacity to bring the vast majority of the population into the ambit of college education is hopelessly limited.

Industry does not suffer from these constraints. It can directly absorb workers from agriculture into productive jobs without necessarily going through many years of education. Many of the skills in industry are acquired on the job. As such what is required for the transformation is a healthy atmosphere for industrial growth, which is lacking even after several years of reforms.

The most urgent reforms needed are in the area of labour markets. The current labour laws not only make the exit of large firms very costly if not impossible, they pose huge barriers to either retrenchment or even reassignment of workers to improve efficiency. There is no doubt that workers’ rights must be protected but there has to be a balance between these rights and the need for efficiency that stands to benefit the vast majority of the work force that remains outside the organised sector and is subject to every conceivable abuse.

At least three arguments continue to be made by those complacent towards labour law reforms, but none holds much water. First, it is argued that many firms have managed to negotiate voluntary retirement schemes and thus managed to exit in recent years. But this misses the point that the critical problem ailing industrial growth is not exit but the entry of new firms that are fearful that entry through a large-scale unit today could become a huge liability tomorrow if the unit is rendered unprofitable. When exit fails to happen or takes a long and painful course, potential entrants are deterred. And even when they do enter, they do so on a small scale that allows them to escape the draconian labour laws but nevertheless places them at a huge disadvantage vis-à-vis their large-scale rivals abroad.

This is not idle theorising. According to the McKinsey Report published a few years ago, even the larger establishments in India in the readymade garments industry rarely employ more than 50 tailors. In contrast, the establishments in China employ thousands of garment workers under a single roof. One can imagine the cost and quality disadvantage facing the relatively tiny Indian establishments.

The second argument made by the defenders of the slow pace of labour market reforms is that large establishments in India are able to get around labour laws by hiring contract workers and rotating them every six months. This solution is not only detrimental to the long-term interests of workers, it gives rise to shoddy product quality and low productivity. This would not have been a serious problem under protectionist policies of yesteryear when the consumer had no option but it is fatal in today’s fiercely competitive globalised market place.

The final argument made to underplay the importance of labour law reforms is that some states may quietly start giving permission for exit within the existing laws anyway. For one thing, evidence that this is happening is shaky and at best anecdotal. But even if such a process is under way, it will do precious little to reassure a new entrant. State governments may give permission for exit today. But if they face political pressures tomorrow, they will simply reverse the policy. It will be many years before entrepreneurs begin to trust state governments for long term stability of their policy.

Of course, the conferment of rights to exit, retrench and reassign workers by itself will be insufficient. Proper bankruptcy laws that safeguard the rights of workers must also been put in place. Also essential to spurring industrial growth is an end to small scale industries reservation. Without this latter reform labour-intensive industries will remain off limits to large-scale firms.

Economic Times, November 19, 2003

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