From Bharat To India, A Commentary By Raghuram Rajan, Economic Counsellor and Director, and Arvind Subramanian, Division Chief, Research Department, IMF

December 26, 2005

A Commentary
By Raghuram Rajan, Economic Counsellor and Director
and Arvind Subramanian, Division Chief
Research Department
International Monetary Fund
India Today
December 26, 2005

Thirty years ago, when India Today was launched, it was a miracle if one was allotted a phone, and after that it took a further act of God and the benevolence of the P&T worker for the phone to work. Thirty years ago, we had black-and-white TVs, and that too only in a few cities. Urban schoolboys like us had to watch Krishi Darshan for entertainment on Doordarshan, where farmers responded to penetrating questions like, "Kya aap khet ko pani dete hain (Do you water your fields)?" Of course, most of the intended audience, villagers, did not have access to TV or the electricity to power it with.

Within a few years of India Today's launch, the Indian economy became a veritable dynamo (we are not suggesting cause and effect here), posting an average growth of nearly 6 per cent per year over the past 25 years. Despite the inevitable, unfavourable comparisons with China, very few countries have grown so fast over such a prolonged period of time, or reduced poverty so sharply. We should indeed be proud of what India has achieved, and clearly, many Indians are. There is a buzz today in India, a sense of limitless optimism. But is it justified?

To answer this question, let us start by asking how we got here. The economic policies that our founding fathers conceived defy easy characterisation. They were an exasperating combination of simultaneously supporting and stifling private entrepreneurship. The barriers erected against foreign competition served to coddle domestic enterprise. But the private sector was kept out of large areas of economic activity. The overarching principle was to prevent wealth concentration in a few hands. So, licensing regulated the scale of operations of every firm; reservations and other carrots favoured small-scale industries; strict labour laws penalised large enterprises and the MRTP Act was the final bulwark against expansion. In short, private initiative and growth, except for a favoured few, were stymied.

So what were the consequences of this jumble of policies for India's pattern of development, circa 1980? First and foremost, these policies held India's growth to a low, but not disastrous, level, famously dubbed the Hindu rate of growth. Surprisingly, these policies did not mean that India produced less manufacturing goods as a whole. It did mean, however, that the composition of its manufacturing activity was unusual: India produced more than its share of capital- and skill-intensive goods (think public-sector petrochemical plant), while underutilising what it had in plentiful supply-its abundant labour. Constrained by regulations and protected from external competition, Indian industry was inefficient and exported very little. There was a silver lining though. India was highly diversified in its manufacturing even in '80. And a portion of its labour force was highly skilled, a clear legacy of Jawaharlal Nehru's emphasis on science, higher education and leading-edge technologies for the public sector. How many nations, at India's stage of development at the time, could boast of a space programme?

Around '80, two major changes began to transform the Indian economic landscape. First, attitudes towards the economy, and the private sector in particular, started to change. Under Mrs. Indira Gandhi and then Rajiv, pro-business reforms were set in motion, with liberalised access for domestic firms to capital imports, technology and foreign exchange, and the gradual relaxation of industrial licensing. Later, in the aftermath of the forex crisis in '90, broader reforms that were more pro-competition were introduced. Second, India started becoming more decentralised politically. The decline of the Congress' power and the rise of regional parties conferred greater political autonomy on the states, translating into autonomy even in the economic sphere. States increasingly prospered, or not, based on what they did, rather than because of the actions at the Centre.

What did these changes accomplish? Many things. Above all, the economy responded with the vigour of an uncaged tiger as per capita growth surged from less than 1 per cent a year to over 3.5 per cent, not so much by employing more workers and capital but by using them more efficiently. Surprisingly, neither the reforms nor the pick-up in growth has altered India's specialisation in capital- and skill-intensive industries. In fact, the fastest growing services-finance, telecommunications and business services-are also skill-intensive. In many ways, India is building on the capabilities created before the '80s, with veterans from the state-owned CMC or ECIL seeding the firms that were in the vanguard of the software boom, and the State Bank of India alumni permeating the financial sector to launch the boom in finance.

These developments are mirrored at the state level. With greater decentralisation, better run states such as Delhi, Gujarat and Tamil Nadu have improved the quality of infrastructure and business climate, attracted more investment, and surged ahead. The pattern of development in these states has been unusual. They seem to have skipped a phase that most high-growth countries in East Asia went through-of specialising in labour-intensive activities. Instead, these states are behaving more like the US and Europe, exploiting their diversified skills, emphasising on skill-based manufacturing (pharma, petrochemicals and auto parts) and services.

So what does this mean for the future? Fast-growing states will need more capital, skilled workers and necessary infrastructure, on which there is a consensus in the country. India has a vibrant financial sector and it should have no problem raising and allocating capital, but for one impediment. The government appropriates significant amounts of savings to finance its deficit. Not only does this leave less to allocate to private investment or infrastructure, it is also a source of vulnerability if the country were to rely more on foreign capital. The need to force-feed the fiscal deficit to domestic banks also makes it hard for the country to open the capital account or to privatise banks, a must if India is to achieve its legitimate aspirations of becoming a world-class financial centre.

The greater bottleneck is likely to be skilled workers. India's universities have not expanded in a way that is commensurate with the growing skill intensity of its production. Even as India redresses its previous neglect of primary education, it needs to multiply institutions like the IITs and regional engineering colleges on which its current success is based. Unfortunately, higher education remains one of the last bastions of the licence-permit raj.

Despite these concerns, India's fast-growing states have a certain success-breeds-success dynamic which will be difficult to derail. More worrisome is job creation for India's growing unskilled labour force and the related problem of laggard states, where the majority of low-skilled, under-educated Indians still reside. Ideally, of course, such states would reform on their own-scrap archaic labour laws, improve infrastructure and business climate-and utilise their vast pools of under-employed, low-cost labour to attract investment in labour-intensive fields. They would then catch up with the leading states in India. Unfortunately, there is a reason these reforms have not been undertaken so far-few things are more persistent than bad governance.

Is India then likely to face increasing political strife as the politically powerful but laggard states hold back the economically powerful, fast-growing ones? There is a more hopeful scenario-Europe had similar disparities but through various initiatives, prosperous western Europe offered incentives for laggard nations to reform. If a loosely knit community of nations can do it, why can't a united nation of states? A reformist centre-India can't afford to not have one-could play the role of the European Commission and offer laggard states incentives to reform.

For India to pull together better, though, the country has to become more of a common market, with easy cross-state flow of people, goods and capital. Harmonisation of taxes, standards and access is necessary. One area where this is critical is education-so that a student from a laggard state can find a place in a Mumbai college as easily as a student from Nagpur-for returning skilled workers can provide these states both the capabilities and the enthusiasm that has been so instrumental in India's growth.

Perhaps the defining metaphor for India today is churning, as entrenched interests lose power, as new jobs are created, as people move across states, as yesterday's Bharat becomes today's India, which becomes tomorrow's Bharat again.


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