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Mystery of India’s economic growth unravelled

Posted on 2007.Oct.10 under Articles, The Economic Times.

For more than two decades, from 1980 to 2003, India’s GDP growth averaged around 6% per year. Reforms in 1990 produced no dramatic acceleration. Then, with no new policy impetus at all, GDP growth suddenly shot up after 2003 to average 8.6% in the next four years. How and why?

One has heard four explanations:

The tipping point thesis: This holds that there were long lags in response to reforms that were gradual and incomplete. The reforms created virtuous cycles in several sectors, but took time to mature. Indian industry and banks learned from the errors of the investment boom of 1994-97 which was followed by a bust.

Indian industry restructured through this trial by fire, which worked wonders. Besides, after 2000, government investment in infrastructure increased, and telecom took off. Overseas remittances shot up. Various virtuous cycles came together, the economy reached a tipping point, and took off.

Thesis of steady improvement, cloaked by exogenous shocks: This says that the pre-reform growth should be derived not from 1980-90 but 1980-92, since slow growth in 1990-92 was a consequence of the 1980s policies. That gives us a pre-reform growth rate of 5.6%. Reforms improved GDP growth, which accelerated to 7.5% in the three-year period 1994-97. Just as things were looking rosy, India was hit by a series of exogenous shocks.

The Asian financial crisis of 1997-99 caused heavy devaluations in competing countries in Asia, a collapse of demand in Asia, and so a collapse of India’s industrial and export growth. There followed the shock of the Pay Commission award, which bankrupted the Centre and states. Soon after came the IT bust and global recession of 2001. India suffered a drought in 2000, followed by the worst drought for decades in 2002.

GDP growth in 1997-2002 slumped to 5.5%. But, according to this thesis, 5.5% was fabulous in the face of horrendous shocks, equivalent to maybe 7% in normal times. And when these negative shocks gave way to a positive shock — the world economic boom after 2003 — growth naturally crossed 8%. This was no quantum jump requiring explanation, according to this thesis, since underlying progress had been steady since 1990.

Thesis of manufacturing catching up at last: Services grew fast by 8-9% in the 1990s, but industry grew by only 5.7%. A sign of the times was that computer software boomed, but computer hardware did not. Many analysts felt India lacked a comparative advantage in industry, and couldn’t compete with China, at least not till its labour laws were amended.

But after 2002 India suddenly experienced a spurt in brain-intensive manufacturing, involving design, customisation and innovation. The pharma industry had moved from reverse engineering to full-blooded molecular research. The auto industry, which requires constant design improvements, took off. So did capital goods, which need customisation. India became a global R&D hub. Total factor productivity shot up.

Meanwhile interest rates fell and Indian access to global capital markets improved. This made Indian manufacturing competitive. So, in 2002-07, industrial growth improved to an average of 8%, and hit 11.5% 2006-07 (with manufacturing growing by 12.5%). The manufacturing spurt buttressed the earlier services spurt, and so GDP growth crossed 8%.

The global boom thesis: The world has experienced an unprecedented economic boom since 2003. Growth in even sub-Saharan Africa accelerated from 2.4% in the 1990s, to 5.5% in the last four years. So, India’s acceleration is unremarkable compared with Africa’s. A global boom has lifted all boats including India. Question: if the tide goes out, will India sink back to 5-6% growth?

The jury is still out on these four theses, which overlap and are not mutually exclusive. There is surely some truth in all four. Yet all four ignore the most striking thing about India’s success — this occurred despite India violating several textbook rules.

The fiscal deficit still over 6% of GDP if we include off-budget items like oil bonds. A deficit of this level has historically sufficed to bankrupt economies across the globe. Keynesians argue that deficits to finance public investment can spur an economy and so is good, but has led to disasters in many developing countries. And in India public spending focuses regrettably more on subsidies than investment — the Centre and states still have revenue deficits.

Subsidies remain a whopping 14% of GDP, as large as in the spendthrift 1980s. Merit subsidies (basic education and health) are fully warranted, but non-merit subsidies are not. Off-budget items like oil bonds are new non-merit subsidies.

The quality of public services in lousy. Surveys show that only half the students in Class VII can read simple texts or do simple maths (unless they have private tutors). Public health is in bad shape. Economists Das and Hammer report that when government doctors are not absent from office, fully half their recommendations are likely to harm rather than cure patients. The quality of bijli, sadak and pani is terrible.

Corruption remains high. Transparency International lists India 72nd out of 180 countries, a poor performance. Nor have reforms been comprehensive enough. The annual Index of Economic Freedom compiled by the Fraser Institute and others puts India at only 104th position in the world.

Supposedly India has rule of law. But enforcement of contracts takes 10 years on average. Politics is criminalised since no criminal is convicted beyond all appeals, thanks to moribund police and courts. Maoist violence now affects 157 out of the country’s 600 districts.

In sum, the quality of India’s policies, institutions and governance leave much to be desired. Other countries with such problems have often suffered economic stagnation or collapse. Yet India has accelerated to 8.6% for four years, a feat rarely achieved in history.

Textbook theories cannot explain this. We are left with sundry explanations that are at best partial truths. We really need a new economics. We need to investigate not only what we know we should, but also seek unknown unknowns (to use Donald Rumsfeld’s immortal phrase).


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