Why India Lags Behind China and How It Can Bridge the Gap
Abstract
Though India has been growing at six per cent annually since the late 1980s, it trails behind China, which has been growing at ten per cent per annum since 1981. The single most important factor explaining this difference is the relatively poor performance of Indian industry. Whereas the share of industry in China's GDP rose from 42 per cent in 1991 to 51 per cent in 2001, it remained virtually stagnant in India. By contrast, services grew rapidly in India, expanding from 42 per cent in 1991 to 48 per cent in 2001. With the information technology sector less than two per cent of the GDP, services growth was largely in the informal sector. Approximately 77 per cent of India's workers live in rural areas. To bring a large chunk of this workforce into the modern sector, India must achieve a much higher growth in the traditional, unskilled-labour-intensive industry. Growth in the information technology sector gives India an extra lever but cannot be the main engine of transformation. Therefore, the right approach is to walk on two legs: traditional labour-intensive industry and the modern IT industry. Both legs need strengthening through further reforms. The paper suggests four specific reforms, three for industry and one for IT, necessary to achieve the transformation to a modern economy.
1. INTRODUCTION
THIS paper pays tribute to V. N. Balasubramanyam, or ‘Baloo’ as his friends affectionately know him, by exploring why, despite some key economic reforms and a major shift in the growth rate, India continues to trail behind China. The paper touches on two specific subjects that have occupied the scholarly writings of Balasubramanyam over the last decade. First, it focuses on the role of manufacturing and software services in the development of India;1 and second, it carries a strong flavour of the most recent work of Balasubramanyam that compares India and China with respect to the development of their textiles and clothing industries.2 I begin by comparing the growth experiences of India and China at a broad level, explaining why China has grown more rapidly than India and suggesting the step which India must take to catch up with China.
In the first half of the twentieth century, India had grown less than one per cent per annum within what was broadly a laissez-faire policy framework under British rule. It was no surprise therefore, that at independence, the national government adopted a strategy that gave the state an active role in catalysing faster growth. Such an approach was also consistent with the then existing conventional wisdom. The Soviet model was regarded as a success and economists generally shared the view that planning was a good way for a developing country to jump-start its economy. The activist role of the state also went well with the then Prime Minister Jawaharlal Nehru's vision of building a socialistic pattern of society in India.
Careful observers of India generally agree that the strategy adopted in the 1950s was largely successful in putting India on a higher growth path.3 During 1951–65, India's GDP at factor cost grew at an annual rate of 4.1 per cent. In the early part of this period, trade and investment policies were still relatively liberal. But by the mid-1960s, India had already gone too far into the interventionist and autarkic direction except in the area of foreign investment policy, which remained liberal. This was in contrast to the economies of East Asia, most notably South Korea and Taiwan, that had by then begun to turn away from import-substitution industrialisation (ISI) and toward outward orientation.
Taking advantage of faster growth in the industrialised countries, many developing countries in Africa, East Asia and Latin America managed to push their growth rates to levels approaching five per cent and higher in the 1960s and early 1970s. But India saw its growth rate decline sharply to 2.6 per cent during 1965–75 (Table 1). While two wars with Pakistan, multiple droughts and a sharp decline in foreign aid were partially responsible for this decline, equally culpable were the draconian policy measures that Prime Minister Indira Gandhi introduced on top of an already tightly controlled regime during the first several years of her reign. These measures included progressively tighter investment licensing; exclusion of large firms from all but a handful of industries; virtually insurmountable barriers against the entry and operation of foreign firms; nearly prohibitive trade barriers; extensive distribution and price controls; nationalisation of banks, insurance and coal mines; and reservation of many labour-intensive products for small-scale enterprises.
| Period | Growth Rate |
|---|---|
| 1951–65 | 4.1 |
| 1965–75 | 2.6 |
| 1975–88 | 4.5 |
| 1988–2004 | 6.1 |
| 1988–91 | 7.6 |
- Source: Author's calculations using the data in Government of India, Ministry of Finance, Economic Survey, 2003–04.
Modest liberalisation in the areas of investment, trade and taxation, which started in the second half of the 1970s but accelerated under Prime Minister Rajiv Gandhi, who came to the helm in January 1985, helped India return to its original growth path. The economy grew at an annual rate of 4.5 per cent during 1975–88, followed by an unusual growth spurt of 7.6 per cent per annum during 1988–91. While the liberalisation measures introduced by Rajiv Gandhi significantly contributed to the spurt during this latter period, an expansionary fiscal policy with deficits partially financed by rapidly rising foreign debt played an important role in it as well. But this fiscal expansion was unsustainable and culminated in a balance of payments crisis in June 1991.
Luckily, Prime Minister Narsimhan Rao, who took office virtually concurrently with the crisis, rose to the occasion and appointed Dr Manmohan Singh, a technocrat with a Ph.D. in Economics from Oxford University, as the Finance Minister. Singh introduced systematic reforms, successfully sustaining the growth spurt of the late 1980s. The subsequent governments broadly stayed on course, with the economy growing annually at 6.1 per cent during 1988–2004.4
2. A COMPARISON WITH CHINA5
Although India is now regarded an unequivocal success, its performance has been less spectacular than its even more populous neighbour, China. The latter has grown at the impressive rate of ten per cent annually during 1981–2003, a rate at which incomes double every seven years.6 Thus, Chinese GDP in 2003 was four times that in 1981. Seen differently, in the late 1970s, China's per capita income was approximately equal to that of India. But with much faster growth, it reached a level more than twice that of India by 2003 –$1,100 per annum in comparison to $530.
China has also been more successful in eradicating poverty. At the turn of the millennium, the proportion of those living below the poverty line fell to five per cent in China compared with 26 per cent in India. These figures are not entirely comparable since they are derived from national poverty lines that are not identical. Nevertheless, they are sufficiently close that the basic message underlying them, namely, that the level of poverty in China is currently far below India's, is not in question.
In the same vein, while both countries have seen their trade grow rapidly, growth of Chinese trade has far outstripped India's. India's share in world merchandise exports, which had declined from two per cent at Independence to 0.5 per cent in the mid-1980s, bounced back to 0.8 per cent in 2002. Thus, since the mid-1980s, India's exports of goods and services have grown faster than the world exports. But this growth is well below the rate at which China has increased its share in world exports. By 2003, China accounted for 5.8 per cent of world merchandise exports and 5.3 per cent of world merchandise imports.
Table 2 offers an overview of the evolution of India's external sector during the 1980s and 1990s in relation to China. The table leaves little doubt that the more significant liberalisation in India in the 1990s led to greater growth of trade during that decade than in the 1980s. Exports of goods and services grew by 7.4 per cent in the 1980s but 10.7 per cent during the 1990s. The pace also picked up on the import side with the growth rate rising from 5.9 per cent in the 1980s to 9.2 per cent in the 1990s. Thus, we have a shift of 3.3 percentage points in the growth rate of both exports and imports. Nonetheless, these growth rates are substantially lower than those experienced by China since that country opened up to the world economy. China's exports of goods and services grew at 12.9 per cent during the 1980s and 15.2 per cent during the 1990s (see the lower half of Table 2). Likewise, imports grew at 10.3 per cent and 16.3 per cent during the 1980s and 1990s, respectively.
| US$ Billion | Annual Growth Rates (Per cent) | ||||
|---|---|---|---|---|---|
| 1980 | 1990 | 2000 | 1980–90 | 1990–2000 | |
| India | |||||
| Total exports (f.o.b.) | 8.5 | 18.5 | 44.9 | 8.1 | 9.3 |
| Manufactures | 5.1 | 13.0 | 34.5 | 9.8 | 10.3 |
| Total imports (c.i.f.) | 15.9 | 27.9 | 59.3 | 5.8 | 7.8 |
| Capital goods imports | 2.4 | 5.8 | 8.8 | 9.2 | 4.2 |
| Fuel and energy | 6.7 | 6.0 | 15.7 | −1.0 | 10.0 |
| Exports of goods and services | 11.2 | 23.0 | 63.8 | 7.4 | 10.7 |
| Imports of goods and services | 17.8 | 31.5 | 75.7 | 5.9 | 9.2 |
| China | |||||
| Total exports (f.o.b.) | 18.27 | 62.09 | 249.21 | 13.0 | 14.9 |
| Manufactures | 9.01 | 46.21 | 223.75 | 17.8 | 17.1 |
| Total imports (c.i.f.) | 20.02 | 53.35 | 225.10 | 10.3 | 15.5 |
| Capital goods | 5.12 | 16.85 | 91.93 | 12.6 | 18.5 |
| Fuel and energy | 0.20 | 1.27 | 26.04 | 20.1 | 35.2 |
| Exports of goods and services | 20.17 | 67.97 | 279.56 | 12.9 | 15.2 |
| Imports of goods and services | 20.86 | 55.54 | 250.69 | 10.3 | 16.3 |
- Source: World Bank: World Development Indicators, 2002.
These higher growth rates are reflected in the higher degree of openness achieved by China in terms of trade-to-GDP ratio. According to Table 3, the ratio of total exports of goods and services to GDP in India nearly doubled between 1990 and 2000 from 7.3 to 14 per cent. The rise was less dramatic on the import side but still significant: from 9.9 per cent in 1990 to 16.6 per cent in 2000. Within ten years, the ratio of total goods and services trade to GDP has risen from 17.2 to 30.6 per cent. Though this is substantially lower than the corresponding ratio of 49.3 per cent for China in 2000 (see the lower half of Table 3), it is comparable to the latter's ratio 12 years after its opening up which stood at 34 per cent in 1990.
| Indicators (Per cent) | 1980 | 1990 | 2000 |
|---|---|---|---|
| India | |||
| Exports/GDP | 4.6 | 5.8 | 9.8 |
| Imports/GDP | 8.7 | 8.8 | 13.0 |
| Exports of Goods and Services/GDP | 6.2 | 7.3 | 14.0 |
| Imports of Goods and Services/GDP | 9.7 | 9.9 | 16.6 |
| China | |||
| Exports/GDP | 8.5 | 17.1 | 23.1 |
| Imports/GDP | 4.2 | 12.7 | 20.8 |
| Exports of Goods and Services/GDP | 9.3 | 18.7 | 26.0 |
| Imports of Goods and Services/GDP | 9.6 | 15.3 | 23.3 |
- Source: World Bank: World Development Indicators, 2002.
The differences in the inflow of direct foreign investment (DFI) into the two countries have been equally stark: they have expanded manifold in India in the 1990s compared with the 1980s but remained less than one-tenth the level achieved by China. The total DFI inflow into India rose from just $97 million in 1990 to $2.3 billion in 2000. In China the figures for these same years were $2.7 billion and $37.5 billion.
3. WHY INDIA LAGS BEHIND CHINA7
How do we explain these differences and what can India do to achieve growth rates comparable to China? For some years now, I have argued that the single most important factor behind these differences is the poorer performance of the Indian industry. Notwithstanding the fact that reforms have primarily focused on industry, it has failed to grow at rates exceeding the rate of growth of the GDP as a whole. This is in contrast to Chinese industry, which has grown at rates significantly higher than its GDP growth rate.
This difference is graphically captured in Table 4, which shows sectoral shares in 1991 and 2001 in the two countries. As one would expect, the share of agriculture in GDP fell with growth in both countries. But whereas industry expanded its share in China from an already high level of 42 per cent in 1991 to 51 per cent in 2001, it failed to make any gains in India: its low initial share of 25.4 per cent in 1991 had barely changed by 2001. In India, it is services that made big gains in the GDP share.
| Sector of the Economy | India | China | ||
|---|---|---|---|---|
| 1991 | 2001 | 1991 | 2001 | |
| Agriculture | 31.5 | 25.1 | 24.5 | 15.2 |
| Industry | 26.4 | 26.5 | 42.1 | 51.1 |
| Services | 42.1 | 48.4 | 33.4 | 33.6 |
- Source: World Bank: World Development Indicators, 2003.
Typically, industrial output is far more tradable than services. Therefore, a low share of industrial output results in a low trade-to-GDP ratio and slow growth in industry translates into slow growth in the latter. Likewise, in labour-abundant economies such as China and India, the direct foreign investment is attracted principally to the manufacturing sector to take advantage of lower wages. Again, slower growth of industry means less direct foreign investment. Through rapid growth in the software and information technology (IT)-enabled services, both of which have a very large traded component, India has had some success in raising the exports-to-GDP ratio despite slow growth of industry. But since these services began with a relatively tiny share in GDP and exports, fast growth has nevertheless had only a limited impact on the share of exports in the GDP in India.
4. WALKING ON TWO LEGS
Some observers react to the failure of the Indian industry to expand its share by arguing 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 later stages. According to these observers, given its vast stock of skilled labour and lead in the information technology sector, it is natural for India to grow rapidly in services, skip industrialisation, 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 it is also 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 its growth has come from informal services where wages and productivity are often low. This is shown in Table 5, which reports the shares of various services sectors in GDP in 1990 and their growth rates in the 1990s. The six largest services accounting for 34.2 per cent of the GDP (out of the total share of services in GDP of 40.6 per cent) are: trade (distribution services), public administration, real estate, community services, transport services other than railways, and banking. Business services, which include software and IT-enabled services, and which grew by a hefty 19.8 per cent in the 1990s, accounted for only 0.3 per cent of GDP in 1990. In 2000, they still accounted for only 1.1 per cent. Likewise, communications services which accounted for one per cent of GDP in 1990, grew by 13.6 per cent during the 1990s and reached two per cent in 2000.
| Sector | Share in GDP in 1990 | Growth in the 1990s |
|---|---|---|
| Trade (distribution services) | 11.9 | 7.3 |
| Hotels and restaurants | 0.7 | 9.3 |
| Railways | 1.4 | 3.6 |
| Transport by other means | 3.8 | 6.9 |
| Storage | 0.1 | 2.0 |
| Communications | 1.0 | 13.6 |
| Banking | 3.4 | 12.7 |
| Insurance | 0.8 | 6.7 |
| Dwellings, real estate | 4.8 | 5.0 |
| Business services | 0.3 | 19.8 |
| Legal services | 0.0 | 5.8 |
| Public administration, defence | 6.0 | 6.0 |
| Personal services | 1.1 | 5.0 |
| Community services | 4.3 | 8.4 |
| Other services | 1.0 | 7.1 |
- Source: Gordon and Gupta (2003).
Even if communications, software and IT-enabled services had a larger share in the GDP, the idea that India can be transformed from a primarily rural and agricultural economy into a modern, urban economy without a substantial jump in industrial growth is a far-fetched one. According to the 2001 Census, 77 per cent of the total Indian workforce continues to live in the rural areas with 58.5 per cent earning a living from farming. While appropriate policies can reasonably be expected to move a large chunk of these workers into well-paid jobs in formal manufacturing activities, they cannot do so if these jobs are to be located in the formal services sectors such as banking, insurance, finance, communications and information technology. The reason is that employment in 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 be absorbed in services when they grow into adult workers. Such a strategy cannot do much for existing adult workers.
Therefore, modernisation which relies primarily on services would have to wait until the labour force can be imparted with the necessary education. But that is not all, since the chances of success of such a policy also rest critically on the ability of the country to mobilise resources to achieve significant expansion of higher education. Currently, only 10 to 12 per cent of young men and women aged 18 to 24 go to college in India. Raising this proportion significantly in the next ten years is beyond the capacity of the government. The proportion of GDP spent on higher education has progressively declined over the last several decades, and given the stringent fiscal constraints faced by central and state governments, as reflected in their combined fiscal deficit in excess of ten per cent 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 adequately even those lucky enough to get entry into them. The physical infrastructure including laboratories (and lavatories!) has been crumbling. More importantly, professors are frequently absent from the classes, ‘moonlighting’ at private coaching institutes that prepare students to successfully compete in various entrance examinations. Yet, if the universities manage to churn out some excellent students, the credit largely goes to the sheer brilliance of the students, superior education they receive in schools prior to reaching the college, and a relatively decent curriculum in colleges that they must master to do well in the examinations that determine their future job prospects.
Therefore, if India is to transition to a modern economy in less than two decades, it cannot escape the industrialisation stage. This is not to suggest that the IT sector need not be a centrepiece of the transition strategy. Given the strengths acquired recently in this sector and its importance even to rapid industrialisation in modern times, it will be foolish for anyone to advocate a transition in which this sector is relegated to the back-seat.
India, therefore, must walk on two legs on its way to transition to a modern nation: traditional industry and IT-related services. Each leg needs to be strengthened through a set of policy initiatives. To boost growth, traditional industry requires reforms in three crucial areas: exit policy through labour-market reform and bankruptcy law; infrastructure; and fiscal discipline. To sustain its current high level of growth, the IT sector requires reforms in higher education and infrastructure.
5. BOOSTING INDUSTRIAL GROWTH
Though substantial progress has been made in a number of areas such as industrial licensing, import liberalisation, small-scale industry reservation, exchange rate management and rationalisation of interest rates, industrial growth has not picked up in a major way. As just indicated, reforms are required in several additional areas.
a. Easing the Exit: Labour Market Reform and Bankruptcy Law
Foremost among the remaining factors constraining Indian industry is a provision in the Industrial Disputes Act (IDA) 1948 relating to the retrenchment and layoffs of workers and closure of firms. Originally, as in most other countries, this law allowed employers to retrench workers provided they followed the last-hired/first-fired rule in drawing up the list of workers to be retrenched, gave a month's notice or pay in lieu of notice, paid half a month's wages per year of service and informed the government.
A strict investment licensing regime and virtual ban on the imports of anything domestically produced had essentially guaranteed monopoly profits to industrialists successful in obtaining the investment licence. Therefore, it was only a matter of time before workers in the organised sector would demand similar protection of their jobs. This demand found a sympathetic ear in the socialistically inclined Prime Minister Indira Gandhi, leading to the 1976 amendment of IDA that inserted the now infamous Chapter V.B. This chapter made it mandatory for firms employing more than 300 workers to seek prior consent of the state government before any retrenchment or closure of a part of the enterprise. Because the state government never gave such permission, retrenchment and layoffs became impossible. In 1982, the government expanded the scope of the law by requiring all firms with 100 or more workers to seek the permission of the relevant state body before any retrenchment.
In view of Chapter V.B of the IDA, the owner of an unviable firm typically has two options. First, he can continue to pay workers from the proceeds of other successful ventures. This is obviously a very expensive proposition and not the one for which entrepreneurs typically opt. Second, he may resort to the so-called practice of ‘lockout’ whereby he stops paying the electricity bill, which eventually leads the state electricity board disconnecting power to the firm. The entrepreneur can then lock the premises, tunnel out the assets and management and flee the state. If the workers of the firm are lucky, the state or central government then takes over the firm declaring it ‘sick’ and refers it to the Board of Industrial and Financial Rehabilitation (BIFR). The BIFR must either rehabilitate or liquidate the firm, giving the workers their due if the firm's assets so permit. The BIFR process itself, however, is extremely slow and takes several years. Of course, in the unluckier case, the government may not take over the firm, leaving the workers with no prospect at all of any severance pay.
This law is an obvious deterrent to the entry of large firms, especially if they happen to have multiple operations in the state, which rules out the option to flee the state, or if the firm happens to be a multinational, in which case it risks damaging its reputation by resorting to the lockout option. The situation is in sharp contrast to that in China, which gave firms in the Special Economic Zones the authority to hire and fire in the very early stage of opening. It then quickly extended this policy to other areas in the country. This labour-market flexibility has been a crucial necessary condition of the growth of manufacturing in China.
It is important to note that the IDA has not been the only barrier to the entry of large firms in India. The so-called Small Scale Industries (SSI) reservation, which keeps a set of products for exclusive production by small enterprises, has also played an important role in blocking the entry of large firms. This is particularly true of unskilled-labour-intensive products such as textiles, clothing, toys, footwear and light manufactures, which had been subject to the SSI reservation until recently. Luckily, this reservation has been ended in a phased manner in the case of most of the labour-intensive products, though a few hundred relatively less labour-intensive products still remain subject to it. This means that in so far as labour-intensive products are concerned, the IDA is now the binding constraint on the entry of large firms.
There are three indirect pieces of evidence supporting the hypothesis that the IDA is a major deterrent to the entry of large firms. First, employment in the private organised sector in India has been low and stagnant.8 It stood at 7.5 million (out of the total number of 313 million workers) in 1991, peaked at 8.7 million in 1998 and fell back to 8.4 million in 2003. Thus, not only has industry grown slowly in India, but the organised sector has also failed to generate significant employment.
Second, if we go by success in exports, entrepreneurs have chosen to concentrate their operations in either skilled-labour-intensive sectors such as drugs, pharmaceuticals, fine chemicals and information technology or capital-intensive products such as automobiles and auto parts. These sectors mainly rely on white-collar workers who are not classified as ‘workmen’ under IDA and therefore do not enjoy the privileged employment status granted by the latter. Thus, between 1992–93 and 2001–02, the share of leather manufactures in total exports fell from 6.9 to 4.3 per cent and of ready-made garments fell from 12.9 to 11.4 per cent. These are both labour-intensive products. On the other hand, chemicals and allied products (which include pharmaceuticals) expanded their share from 6.6 to 9.2 per cent. Likewise, engineering goods, which include automobiles and auto parts, rose from 13.4 to 15.7 per cent.
Finally, though the exemption from the SSI reservation in several products for export-oriented units has been in place for some years, there has not been significant entry of large firms in these products. This also indirectly points to a continued role of the IDA in discouraging the entry of large firms in labour-intensive products.
In 2002, the Bhartiya Janata Party (BJP)-led National Democratic Alliance (NDA) government considered amending the IDA by raising the limit beyond which the firm must seek the state's permission to retrench and layoff workers from 100 to 1,000 with the provision that the workers be paid as much as 45 days of severance salary for each year served. Because of heavy opposition, the limit on the firms to be freed of the IDA provision was later revised to 300. But even then, the government could not gather enough support and never introduced the Bill to amend the IDA in Parliament. Unfortunately, the current Congress-led United Progressive Alliance (UPA) government, which relies on the support of the left-wing parties to maintain a majority in Parliament, has explicitly committed itself to not amending the IDA. This makes the prospects for a change under the current government quite dim.
Currently, India also lacks a modern bankruptcy law. As noted earlier, the current bankruptcy procedure involves first declaring the firm sick on the basis that its liabilities exceed its assets and referring it to the BIFR. The BIFR then makes a determination as to whether the firm can be restructured and, if not, initiates liquidation proceedings. The BIFR process is extremely slow and often takes ten years or more. A bankruptcy law that allows creditors (including workers) to initiate bankruptcy proceedings in case of non-payment of dues must replace this procedure. Also important is a time-bound resolution of the ensuing bankruptcy proceedings.
b. Improving the Infrastructure
The need for investment in infrastructure – especially power, roads, ports and airports – is well recognised. While the IT industry has managed to flourish by relying on even the high-cost internal sources of power, traditional industry cannot afford this option. If it is to compete effectively internationally, it must have a reliable power supply at rates comparable to what its competitors pay abroad. Likewise, congestion at ports due to capacity constraints and poor administration hamper the swift movement of the goods into and out of the country. In the super-competitive global marketplace, this bottleneck can seriously hamper the chances of success. Airports in India are a virtual embarrassment: a potential foreign investor who takes a flight from New York to Shanghai and then to Bombay or Delhi will think twice about investing in India. Finally, the movement of goods to and from ports requires the construction of reliable roads, development of a modern trucking industry and removal of restrictions on the movement of freight carriers. At present, the time taken by cargoes to and from ports within the country is many times more than the international standard. Given that the state will have to remain involved in these sectors in a major way for a variety of reasons, participation of the leadership at the highest level is essential.
Perhaps the greatest progress in recent years has been made in the area of roads. The government launched the National Highway Development Project (NHDP) aimed at turning 13,252 kilometres of national highways into four- or six-lane roads. The project had two components: (i) the Golden Quadrilateral (GQ) connecting four metropolitan cities of Delhi, Bombay, Chennai and Calcutta (5,952 kilometres) and (ii) North-South and East-West corridors (7,300 kilometres), connecting Srinagar to Kanyakumari and Silchar to Saurashtra and Salem to Cochin. The project is estimated to cost 540 billion rupees at 1999 prices (approximately $11 billion). As of 31 December, 2002, the government had turned 1,218 kilometres of the GQ highway into a four-lane highway and expected to convert another 4,492 kilometres by 31 December, 2003. On the North-South and East-West project, it had converted 817 kilometres as of 31 December, 2002, and expected to convert another 617 kilometres by 31 December, 2003.
The main areas in need of greater attention are regulations relating to transportation companies and civil aviation. If India is to take advantage of the vast road network it is creating, it is important that eventually freight movement shifts largely away from railways to roads. Railways should be left mainly to move passengers at reasonable fares, which are likely to continue to be below the level necessary for full-cost recovery for a considerable time. In turn this requires the modernisation of laws governing the entry and exit of transport companies. Restraints on the size and operations of transportation companies that move goods across states, if any, should be removed. There are substantial network economies in this area and efficiency will dictate the emergence of a few large transport companies that will move the bulk of the freight while smaller companies move goods locally. The reform of labour laws will be crucial to this sector as well since large companies will be deterred in the absence of the right to retrench workers.
Civil aviation is also in need of reform. The policy of bilateral slot trading has resulted in a chronic shortage of flights to India, thereby depriving it of substantial revenues from international tourism. This policy must be replaced by one that gives relatively free entry to airlines wishing to fly in and out of India. Air India remains hopelessly inefficient and costly and should be privatised. Entry into the domestic segment of the civil aviation market has been opened wider recently and this has had a dramatic effect on prices. Further liberalisation in this direction will help reduce pressures on passenger transportation by road and railways and provide an inexpensive means of quick transportation for entrepreneurs. India also needs to construct more airports and modernise existing ones. At present, airports even in the major cities of Delhi and Bombay are well below international standards and very congested. Moreover, access from the international airport to the domestic ones is poor. In most countries, passengers can walk from the international to the domestic terminal.
The most critical infrastructure sector in need of reform is power. Without a reliable supply at reasonable cost, rapid industrialisation is unlikely. Even after all policy barriers are removed, large-scale establishments will hesitate to enter the market unless they are assured of a steady supply of power. The current mess in the power sector in India is well known and need not be repeated here. Attempts at reforms in different states over the past several years have failed to yield almost any successes. In this respect, the experiences with telecommunications and power sectors have been quite different. In part, this has been due to inherent technological differences: theft and non-payment are much easier to handle in telecommunications than power. The supplier can turn off the dial tone to a customer from a central facility if the latter fails to pay the telephone bill. But when it comes to power, he must physically cut the wires at the customer end in case of non-payment, which can readily turn into a law-and-order problem. Moreover, politically, denial of access to telephone without payment is more readily acceptable than of power supply, especially if power users happen to be poor or in the farm sector.
This key problem in expanding the base of paying customers has meant that during the reform, electricity-distribution entities, whether State Electricity Boards or independent corporate entities, have tried to reduce losses by raising the tariff on the existing paying customers. At the same time, they have failed to improve the availability or reliability of electricity services. Given the poor health of the State Electricity Boards, which with some recent exceptions remain monopoly buyers of electricity from generation companies and monopoly sellers to consumers, few private generation companies have entered the market. Without extra supply, there is little scope for improvement in service. The result has been that the reform has come to be associated with increased tariffs without improvement in service. This is in stark contrast to the telecommunications sector, where the reform has been accompanied by not just improved service but also dramatic reduction in the tariff, especially when the improvement in the quality of service is taken into account.
The Electricity Act 2003, which was passed under the NDA government and replaced the three existing legislations in the sector dated 1910, 1948 and 1998, offers a comprehensive framework for restructuring the power sector. It builds on the experience in the telecommunications sector and introduces competition through private sector entry side by side with public sector entities.
Under the Act, the Transmission Utility at the central as well as the state level is to be a government company with responsibility for planned and coordinated development of transmission networks. The private sector is allowed to enter distribution through independent distribution networks and has open access to transmission at the outset. Open access is to be introduced in phases with surcharges for current levels of cross-subsidy to be gradually phased out along with an obligation to supply. State Electricity Regulatory Commissions, made mandatory by the Act, are to frame regulations within one year regarding phasing of open access in distribution.
The Act fully de-licenses generation and freely permits captive generation. Only hydro projects would henceforth require clearance from the Central Electricity Authority. Distribution licensees would be free to undertake generation, and generating companies would be free to take up distribution businesses. Trading has been recognised as a distinct activity with the Regulatory Commissions authorised to fix ceilings on trading margins, if necessary.
A second track of reforms has involved the states signing memorandums of understanding (MOU) with the centre under which they are offered financial resources contingent on satisfying certain performance criteria. The MOU milestones include consumer metering, energy audit, control of theft, tariff setting by the State Electricity Regulatory Commission and timely payment of subsidies.
All these steps are likely to move the power sector in the right direction. With the generation companies allowed to sell electricity directly to both bulk and retail buyers, they have a much greater incentive to enter. Likewise, given the scope for entry of independent distributors and availability of open access to transmission lines will allow the private sector to compete against public sector entities directly for consumers. This is bound to place enormous pressure on public sector entities to cut costs and raise revenues through better metering, reduced theft and distribution losses and related measures.
The change of government at the centre, which brought the UPA to power, has slowed the implementation of the Electricity Act. Left-wing parties are not warm to the idea of private sector involvement and have insisted on a review of the Act. This is unfortunate since India can ill-afford to delay reforms in this sector.
c. Restraint on the Fiscal Deficit
Indian industry is also starved of investment funds, which must come from one of three sources: private savings, government savings or foreign savings. Foreign savings available to an economy equal the current account deficit. They represent the amount foreign countries loan the country so that it can buy more goods and services from the former than it sells to them. Because large current account deficits carry the seeds of a balance-of-payments or exchange rate crisis, to which India is very averse, this source of savings is limited to at most two or three per cent of GDP on a sustained basis. The government savings equal the negative of the fiscal deficit, which has been running at an average of ten to 11 per cent in India in recent years. Once we exclude household investment and corporate savings, the financially intermediated savings are in the 12 to 13 per cent range. Thus, the government effectively mops up much of the financially intermediated savings. What this means is that if private investment is to rise – an essential ingredient in pushing up industrial growth – either the rate of private savings must rise or the fiscal deficit must fall. Given that the savings rate is beyond government control, this leaves a reduction in the fiscal deficit as the only viable option in the short term.
But it is not merely a reduction in the fiscal deficit that is important for increasing availability of investment funds to private entrepreneurs. The manner in which the deficit is reduced is also important. Private savings themselves depend on the taxes paid by households and corporations. Therefore, if the deficit is reduced mainly through an increase in taxes, the latter will substantially crowd out private savings. Therefore, the increase in available investment funds will be far less than the reduction in the deficit. The upshot is that the government must also work on bringing its expenditures down. At present, there is substantial scope for such reduction since the expenditures include many unproductive subsidies that distort prices. What seems to be lacking is the political will to cut subsidies.
6. SUSTAINING GROWTH IN THE IT SECTOR
One of the best things to happen to India during the 1990s was the growth of the IT sector. Gradual liberalisation, which started in the mid-1980s and accelerated in the 1990s, gave the sector access to world-class hardware. Moreover, it was largely free from other regulations including the draconian labour laws (since it principally employs white-collar workers). Therefore, when world markets offered growth opportunities, it was able to take advantage of them. The key question confronting the sector now is whether it can continue to grow at its current pace.
There is some reason to fear that despite its current leadership status, even in this sector, India may be crowded out by China. For example, India's advantage in English over China has been eroding rapidly in recent years. Chinese students coming to the United States today are much more fluent in English than those coming ten years ago, so the gap in language skills between the two has been declining. China has also been bridging the gap in technical education. The impact of these developments is reflected in the growth of the IT sector in China and exports of software and IT-enabled services by it.
But potential competition from China is perhaps not the major source of worry for India for two reasons. The total demand for outsourcing activities from developed countries will continue to grow sufficiently rapidly that India is unlikely to experience a major slowdown in expansion of demand. Moreover, India will continue to enjoy the advantage emanating from greater cultural and institutional affinity with Western nations than China.
Bottlenecks on the growth of the Indian IT sector are likely to arise from the supply side instead. Most jobs in this sector require some college education. Unfortunately, India's higher education system is starved of resources and is currently incapable of producing the large number of high-quality students that will be demanded at current wages by the outsourcing industry. According to the 2001 census, there were only 12.6 million workers with non-technical undergraduate or higher degrees and 2.3 million with technical undergraduate or higher degrees in urban areas. These workers represent less than four per cent of the total workforce of 398.8 million counted by the census. Moreover, at present, even with only 10 to 12 per cent of the population in the college-going age group (18 to 24 years), India's colleges and universities are stretched to the limit along quality as well as quantity dimensions.
While there are no quick fixes to solve the problem of higher education, India must begin the work on four fronts. First, entry of private universities, so common around the world including Bangladesh and China, must be introduced. The government has no resources to expand higher education at a pace consistent with demand. Nor is it in a position to create many Indian Institute of Technology (IIT) and Indian Institute of Management (IIM) like institutions with public resources. Only private universities that can charge hefty fees and attract private sponsors from home and abroad will be able to afford salaries necessary to retain top-class scholars and teachers and create facilities required to promote excellence in research.
To be sure, there has been at least an intellectual recognition of this need at the official level as evidenced by the Private Universities (Establishment and Regulation) Bill, 1995, and the recommendations of the Core Group of six members appointed by the Human Resources and Development (HRD) Ministry in 1999. Additionally, the issue has been widely discussed in various forums with the Education Committee of the Federation of Indian Chamber of Commerce and Industry offering excellent ideas within the Indian context. The sad reality, however, is that there has been little real action by the government and the 1995 Bill has been ‘pending’ in the Rajya Sabha (Upper House of the Parliament).
Second, even at the college level, where the private sector is currently permitted to operate, there is a need for deregulation. The process of entry should be relatively simple and transparent. The limits on the number of students these colleges can currently admit should be abolished. Under the current rules, private engineering colleges usually lack the freedom to choose their own students or charge fees beyond a tiny fraction of those admitted. As a result, fees from a small fraction of the students pay for the entire college. While a strong case can be made for admissions on merit and scholarships cum loans to the admitted students unable to fully afford the fees, there is little justification for a blanket exemption or near exemption from fees for a large fraction of the students at private colleges.
The third necessary step is to loosen the stranglehold of the University Grants Commission (UGC) and give greater autonomy to universities and colleges. In this respect, India's own experience has been consistent with that of the rest of the world: institutions such as the IIT and IIM. These highest-quality institutions in India have been outside the UGC ambit. The Education Committee of FICCI has rightly suggested giving greater play to unitary (rather than affiliating) universities. Like the IIT and IIM, such institutions will be better able to maintain uniform and high-quality standards.
But India needs to go farther. After more than 50 years of independence, India should be willing to confer greater responsibility on the universities in general so that they can make informed decisions on courses, curricula, degrees, research centres, and types of academic appointments based on local needs and competitive pressures from peer institutions. It is likely that the initial impact of autonomy on a wide scale would be adverse but it is time to begin laying down the groundwork for a modern education system, which requires increasing decentralisation and local responsibility. In the 1950s and 1960s, when India was dealing with a small number of universities and colleges, it was possible for the UGC to centrally control and regulate the process. But with more than 250 universities and 10,000 colleges, this is no longer an efficient form of organisation.
Finally, it is essential to state the obvious: India needs to gradually raise the tuition fees from their existing negligible levels. Unlike primary and secondary education, benefits of higher education accrue largely to those who receive it. While provisions for loans and scholarships for the talented among the poor must be made, there is little justification for burdening the taxpayer with the expenses that lead to private gains for those lucky enough to find spots in colleges or universities. According to the Justice Punnayya Committee, appointed by the UGC in 1992 to advise on how to fund higher education, tuition fees accounted for 15 to 20 per cent of university expenditures in the early 1950s. Today, they account for less than three per cent. This is ironic since rising incomes should have increased rather than decreased the contribution.
It bears noting briefly that the IT industry too will benefit greatly from infrastructure development. The rudimentary roads and airport in Bangalore – a city that is so much feared by the professional workers in developed countries – invariably shock a first-time visitor to this city. The city stands in sharp contrast to the premises of its major suppliers of the IT services such as Infosys and Wipro that rival their developed country counterparts. Building up the infrastructure in the major hubs of the IT industry should be a national priority.
7. CONCLUDING REMARKS9
Having sustained six per cent annual growth since the late 1980s, India is now regarded as an unequivocal economic success. But it continues to trail well behind its equally populous neighbour, China, which has been growing at the annual rate of ten per cent since 1981. From an equal level in 1980, per capita income in China today is more than twice that in India. The proportion of the population below the poverty line has dropped below five per cent in China compared with 26 per cent in India.
Though trade has grown rapidly in both countries, it has grown far more rapidly in China. In the 1990s, exports of goods and services grew at an annual rate of 15.2 per cent in China compared with 10.7 per cent in India. By 2003, China's share in world exports hit 5.8 per cent while that of India remained virtually invisible at below one per cent. Direct foreign investment (DFI) in India expanded greatly in the 1990s over the 1980s 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 per cent in 1990 to 51 per cent in 2000, it remained virtually stagnant in India. By contrast, services grew rapidly in India, expanding their share from 41 per cent in 1990 to 48 per cent in 2000. This trend has continued in the last five years.
Industrial output is far more tradable than services. Information technology (IT) services are an exception in having a large traded component but they are less than two per cent of India's GDP. Therefore, a low share of industry and slow growth in it translate into a low trade-to-GDP ratio and slow growth in trade. Moreover, in labour-abundant economies such as China and India, DFI is attracted principally to industry to take advantage of lower wages. Again, a low share of industry means less DFI.
Some observers argue that India can achieve the same transformation as China by specialising in services. If the bulk of the recent growth in services in India had been in formal services such as telecommunications and information technology (IT), this strategy would make eminently good sense. But these sectors are currently tiny with distribution services, public administration, real estate, community services and transport services accounting for 70 per cent of services output.
Moreover, approximately 77 per cent of India's workers live in rural areas with 59 per cent earning their living from farming. These workers cannot be drawn into formal services without being taken through 15 or more years of education. 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 reasonable amount of time is through faster expansion of the traditional, unskilled-labour-intensive industry.
This suggests the right strategy for India is to walk on two legs: the traditional labour-intensive industry and the modern IT industry. Both legs need strengthening through further reforms. Four specific reforms are of special importance, the first three for industry and the last one for IT.
First, under a key law 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 labour-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 law by focusing on skilled-labour-intensive or capital-intensive sectors such as pharmaceuticals, IT, machine tools and auto parts, which principally employ white-collar workers who do not enjoy the protection provided by the 1982 law. Restoration of the firms’ right to fire workers in return for a reasonable severance package is essential if India is to be transformed into a modern nation.
Second, the combined fiscal deficit of the centre and states at more than ten per cent has starved industry of investment funds. Savings by households and corporations in India currently average 26 per cent of GDP. After excluding household investment and retained earnings of corporations, financially intermediated savings are approximately 12 to 13 per cent of the 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 releasing investment funds to industry.
Third, Indian industry needs better infrastructure. To effectively compete internationally, it needs a reliable power supply at reasonable prices. Congestion at ports due to capacity constraints and poor administration hamper swift movement of goods in and out of the country. Airports in India are an embarrassment: a potential foreign 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 construction of reliable roads, development of a modern trucking industry and removal of restrictions on the inter-state movement of freight carriers.
Finally, the most important potential bottleneck which the IT sector faces in India is the state of higher education. Currently, only 10 to 12 per cent of young men and women aged 18 to 24 go to college. Of these only a tiny fraction have the skills necessary to perform tasks related to software and IT-enabled services. Unsurprisingly, the competition for scarce skills has brought the annual employee turnover rates in the IT firms to more than 50 per cent and the 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 fiscal deficits of ten per cent or more, the government has virtually no resources to expand and improve the education system. This leaves only two complementary options: entry of private universities; and the introduction of tuition fees in public universities for those capable of paying them. The persisting virtual ban on entry of private universities in India is most puzzling. Many students would be willing to spend significant sums of money for a decent education as evidenced by the large expenditures they currently incur on education in US universities. Likewise, given the high private returns to higher education, there is 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.
