World Marketplace
India Ascendant
Sunil Khilnani
09/01/2004

India’s democracy has long been one of the wonders of the world. This country of more than 1 billion people—most of whom are poor and lack a formal education, and over two-thirds of whom live in the countryside—has sustained, since its independence in 1947, a robust, sometimes tumultuous political tradition. By contrast, India’s economy has been something of a cabinet of curiosities, where extreme opposites jostle side by side. A lumbering state-controlled sector, still directed by five-year plans, coexists with some of the world’s most dynamic high-tech companies and scientific research centers. The consuming aspirations of an exuberant middle class are fed by nimble private entrepreneurs, while some 300 million others live on less than $1 a day.

Investors, particularly those with short attention spans, should certainly approach India cautiously, and brace for political surprises. These undulations are an authentic expression of a uniquely complex society.
The results of the general elections in May—in which the opposition Congress Party defeated the governing coalition, led by a Hindu nationalist party—testify to the intricacy of this massive cociopolitical enterprise. It was a dazzling affirmation of the political freedoms that Indians possess, but also raised questions about the direction and character of India’s economic future. The markets greeted the Congress Party’s return to power, after eight years in opposition, nervously, interpreting the result as a mandate against the program of economic reforms that India has gradually pursued since 1991. Investors who had once piled in enthusiastically now withdrew, fearful that the new government and the communist parties on whose support it relied might slow or even stop liberalization. However, those who reacted this way misread both the immediate situation as well as India’s deeper trends.

Investors, particularly those with short attention spans, should certainly approach India cautiously, and brace for political surprises. These undulations are an authentic expression of a uniquely complex society, whose economy varies sharply between regions and sectors. India’s most prosperous state, Punjab, boasts a per capita income five times higher than the poorest one, Bihar, while communist-governed Kerala’s 94 percent literacy rate contrasts with that of just 38 percent in Bihar. Such disparities, in a federal system of 28 states xperiencing rapid and uneven social change and where expectations are rising fast, are a recipe for political volatility—and will from time to time find voice in populist parties and programs.

Pragmatic Accord
Despite this, India’s economic reform process is irreversible, based as it is on a consensus that extends across all political parties. Although some raised the specter of a swing back to the era of state control—the license-permit Raj—India’s pragmatic economic tradition renders such worries baseless. Even in West Bengal, where communists have governed since the 1970s, companies like IBM have recently been welcomed with special provisions. (For example, the government insulates the software industry from labor strikes.)

In a paper published last year, Goldman Sachs estimated that India’s economy could be larger than Japan’s by 2032, and by midcentury, per capita income will have increased 35 fold.
Further, the new prime minister, Manmohan Singh, inherits not just a healthy economy, but one that he did much to create. A professional economist with an Oxford PhD, Singh was last inducted into office as finance minister during India’s worst economic crisis, in 1991, when the country found itself with just two week’s worth of foreign exchange reserves. In 2004 he takes charge of a treasury with foreign exchange reserves nearing a record $120 billion. GDP growth in the first quarter of 2004 surpassed 10 percent, and it may be as high as 8 percent for the year. India’s skilled service sector, spearheaded by its software industry (which grew by 30 percent last year), continues to consternate the developed economies.

Deeper trends underpin this recent bounty. India has decisively pulled itself out of a decades-long economic waddle, which yielded steady but modest expansion of around 3.5 percent a year—famously dubbed the “Hindu rate of growth.” Since the 1980s, annual growth has averaged around 6 percent, and the 1990s saw the fastest growth in India’s recorded history. Poorer, late-developing countries have the potential to catch up rapidly. In a paper published last year, Goldman Sachs estimated that India’s economy could be larger than Japan’s by 2032, and by midcentury, per capita income will have increased 35 fold.

The fundamental resource that will drive India’s economic rise is its people. By 2050, India will surpass China as the world’s most populous nation, and its citizenry is increasingly youthful. India is only just beginning to experience what Japan, Western Europe and the United States have already passed through: a youth bulge. In these economies, and in those of East Asia, the working population is declining as people age.

The country’s class of talented private entrepreneurs is only beginning to tap India’s large, youthful and poor labor pool. Many indigenous start-ups have grown into global success stories. The best known are software companies like Wipro and Infosys, but they are also to be found in pharmaceuticals—Ranbaxy, Dr. Reddy and Cipla—as well as in more traditional sectors such as automotive parts and steel. These companies, which raise money from India’s developed capital markets and benefit from low interest rates, are now looking to invest beyond its borders. Indian business has thrived in this more competitive atmosphere since the 1990s. In an important analysis of India’s recent growth, Dani Rodrik, of Harvard, and Arvind Subramanian, of the International Monetary Fund, have shown that much of this success was the result of more efficient use of resources, men and machines. The productivity that is driving Indian growth over the past two decades is close to the highest in the world.

Policy Pitfalls
India’s current push for growth will come up against significant barriers if it cannot finesse its main foreign policy challenge. South Asia is today the least integrated of all Asia’s regions, with minuscule levels of cross-border trade among its seven countries. The greatest obstacle to closer integration and higher growth is the almost 60-year conflict with Pakistan over the state of Kashmir, a dangerous face-off between two nuclear powers. The new Indian government has committed itself to furthering the peace process, but much will depend on how Pakistan responds. Both sides need to recognize that high economic stakes trump narrow issues of sovereignty. The South Asia market contains 1.4 billion people, and the different national economies complement each other in significant ways. When it finally emerges as an integrated economic region, India will be its economic engine, and the rewards of growth will be plentiful.

Domestically, India’s fiscal management has typically been prudent, and committed to economic stability. Unlike many other developing economies, India has never had extended periods of high inflation, because governments have not resorted to printing money to get themselves out of trouble. Yet the managers of India’s public finances now face a major task in taming the country’s fiscal deficit, which amounts to roughly 10 percent of GDP, and slows growth by swallowing a large chunk of India’s private savings.

More than 40 percent of the government’s recurring expenses involve servicing past borrowings, and much of the remaining revenue pays for salaries, defense and subsidies. Cutting the deficit is difficult because subsidies have hardened into a fixture of the country’s political economy. Free electrical power and fertilizers are used to buy off prosperous farmers, while tax breaks and preferential savings rates keep middle-class voters smiling. Governments have shied away from confronting these powerful electoral groups, and the new one is likely to try to address the deficit by improving tax revenues—which at present are only 14 percent of GDP.

Within these constraints, very little is left for social spending on education or health, and on physical infrastructure. Because of this, India will need to hand off the financing and development of power, transport and airports to the private sector. (India’s mobile telephony market, which is the fastest growing in the world and is projected to reach 100 million subscribers by 2010, is an outstanding example of the success of such a strategy.)

Colonial Memories
Indigenous capital has financed most of India’s growth so far; the country sees barely one-tenth of the $50 billion direct foreign investment that China sees every year. However, foreign investors who want the sort of freedom from regulations they enjoy in China’s special economic zones, or to extract massive profits, will be disappointed. Exploitive projects like Enron’s power plant at Dabhol, accused of having a distorted pricing scheme, will run into popular opposition that draws on India’s colonial experience, as well as its democratic traditions.

India needs jobs above all. Its service sector, with its software flagship, now accounts for half of India’s GDP. But the software industry employs fewer than a million Indians, from a labor pool of 470 million, to which 9 million are added every year. Agriculture (which accounts for less than a quarter of GDP) and industry have been painfully slow to grow. As a result, the economy is creating less than half the number of jobs it needs each year, leaving around 5 million more youths without prospects. Growth and modernization inevitably bring social strains in their wake, and India may face more than its expected share unless it can spread the benefits of that growth by expanding employment opportunities.

Over the past six decades, India has invested consistently in its political and legal systems, and has accumulated considerable institutional capital to deal with problems of social development—something that again sets it apart from China. Democracy and its institutions provide India with powerful mechanisms of learning and self-correction. These mechanisms, for all their flaws, are more stable (because they are more supple) than those of solid-seeming China. India’s more gradualist, consensus-building path to liberalization should thus ensure a more durable basis for growth within a diverse society. The new Indian government seems poised to demonstrate that even in a country of unprecedented complexity, political freedom and sustainable economic growth may coexist.

Sunil Khilnani is the author of The Idea of India and director, South Asia Studies, at Johns Hopkins University’s School of Advanced International Studies in Washington, D.C.