As we near the completion of the first quarter century of this millennium, it's worth taking stock of the Indian economy and examining its challenges. This post draws together several strands that have been a recurrent theme in this blog.
The Indian economy underwent an episode of healthy growth (2003-08) till the global financial crisis (GFC) hit. This period was marked by high corporate sales and profits, rising domestic savings, peak gross fixed capital formation, especially by the private sector, rapid export growth, peak tax-GDP ratio, and favourable global conditions. The post-GFC economic slowdown and fiscal profligacy of the government left corporates over-leveraged, the banking sector with a large pile of non-performing assets (the twin-balance sheet problem), and governments with large deficits. All this coincided with a period of Eurozone crisis and weakening global economic conditions, and corruption scandals and decision paralysis at home, which further dampened growth.
After the government changed in mid-2014, on the back of a recovery in public investments and disciplined project execution, the economy picked up some steam and grew rapidly for a short period. This and macroeconomic stability allowed for corporate deleveraging, and prudent policies and recapitalisations restored bank balance sheets. But the demonetisation and GST were either negative shocks or dampeners on the economy. From the first quarter of 2018, there were seven consecutive quarters of declining growth, touching a low of 3.3% in the last quarter of 2019. It was this declining economy that entered the pandemic shutdowns and eighteen months of pandemic-related uncertainties.
India weathered the pandemic disruptions with perhaps the smallest economic stimulus among all major economies, preferring a combination of targeted welfare support revolving around Public Distribution System (PDS), National Rural Employment Guarantee Scheme (NREGS), and Direct Benefits Transfer (DBT), credit guarantees to Micro-small and medium enterprises (MSMEs), and a broad swathe of liquidity support measures by the central bank. It chose to instead use the additional public borrowing space from the relaxation of the budgeting rules to expand capital expenditures, while tightly monitoring its quality.
On the external front, the repeated Covid disruptions were compounded by the Russian invasion of Ukraine, the uncertainties from the emerging Cold War between China and the West, and a trend of rising trade protectionism and backlash against immigration and globalization. Into this mix comes the second Donald Trump Presidency, with all its uncertainties and potential for instability.
As stylised facts for this period, since about 2010, but for some blips there has been a steady decline in some of the foundational parameters of sustained growth – gross domestic savings as a percentage of GDP, gross fixed capital formation as a percentage of GDP, export growth rate, corporate sales and profits, etc. While there has been a small uptick since the pandemic, it remains to be seen whether it can be sustained, much less recover the considerable gap to reach the levels that supported the growth episode of the noughties.
Further, the tax to GDP ratio, the measure of the central government’s fiscal space, has remained anchored in the 10-11.5% range. Manufacturing’s share of the GDP has remained persistent in the 12-13% range for decades. Alongside this, the country’s structural transformation has stalled and, indeed, has even shown signs of reversing course in recent years with increases in the share of the population supported by agriculture. Also, India has not been immune to the global trends in business concentration and widening inequality.
Finally, on the political economy, there has been a proliferation of competitive populism revolving around cash transfers that has distorted priorities and is now threatening to create fiscal crises in many states.
With the backdrop of this description, what are the salient features of the Indian economy today?
The mainstream narratives on India’s growth prospects have been spun around its emulation of the Northeast Asian, specifically Chinese, economic growth trajectory. This has raised expectations about decades of 7-9% economic growth rates.
However, commentators and experts’ discussions and comparisons of India’s prospects with the growth trajectories of the East Asian countries miss important differences. While India of the 1960s was richer and more developed compared to, say, South Korea, it was far behind in the quality of human capital, gender and social equity, and state capability. These are essential ingredients required to support broad-based economic growth. Further, as Joe Studwell and others have shown, the spectacular growth of Northeast Asian economies happened on the back of long-drawn and broad-based capital accumulation through intensified agriculture, infrastructure investments, and importantly government-guided export-led industrialization.
In this context, a historically disturbing feature of the Indian economy has been its narrow overall capital base. It has struggled to strengthen and expand the base of its human, physical, industrial, financial, institutional, and social capital. This manifests in poor quality of student learning outcomes, weak primary and public health indicators, deficient infrastructure, narrow meaningful consumption class, missing middle among companies, excess of subsistence entrepreneurship and scarcity of scale manufacturing, fragmented farms and low agricultural productivity, and poor capabilities of its service delivery and regulatory institutions.
This narrow capital base naturally imposes inherent limits on the pace at which the country can grow. If it grows at too rapid a pace, it risks overheating and opening fault lines in a short time. Given its economic structure, it may not be incorrect to argue that the Indian economy with its present base and structure cannot support sustained episodes of high growth rates of the kind experienced by the Northeast Asian countries.
Fortunately, much has been done over the last ten years to provide macroeconomic stability and expand infrastructure, and in some sectors, there have been transformational changes. A robust push on industrial policy through the Make in India and Production-linked Incentive (PLI) scheme has undoubtedly stoked interest in manufacturing. There have been serious efforts to improve the ease of doing business, lower compliance costs, and expand the tax base. A big boost to corporate competitiveness came in the form of the steep reduction in corporate tax rates from 2020-21. Other reforms like the GST and the Insolvency and Bankruptcy Code (IBC) will most likely start to show results in time.
However, there has not been a similar focus on improving the quality of human capital and state capabilities. The state of education, from primary school to colleges, remains a matter of deep concern, perhaps the country’s biggest developmental and governance failure. No matter even major macroeconomic and other reforms, the poor general quality of human capital that enters its workforce is a binding constraint on economic growth.
An equally disturbing trend has been the failure to deepen and broaden the economic base consisting of productive firms and consumers with disposable incomes. Apart from public policy failures, perhaps a more important factor in this failure to broaden the base has been the reluctance and inability of India’s private sector to play its expected role. Governments can only do so much.
Despite years of deleveraging and record profits, investments in productivity improvements during the pandemic, and an economy which has been the fastest-growing major economy globally, corporate India has been found missing in action in complementing the government’s efforts to push economic growth. Specifically, I can think of six practices of corporate India that have been damaging – wage stagnation, jobless growth, a preference for low-cost contract labour, reluctance to undertake investments, low level of R&D expenses, and a preference for serving the domestic market instead of competing globally (with all attendant distortions).
The abysmally low level of R&D expenditures, even among its vaunted IT and pharmaceutical firms, should be a matter for collective introspection by corporate India. This trend is also reflected in its vibrant start-up sector. Despite the proliferation of several unicorns and decacorns, they are engaged with copying innovations and technologies deployed in advanced economies. There are very few engaged in frontier technologies, or in areas that target the country’s major development problems and can be transformational in addressing them.
So, what has kept the economy growing at a good pace in recent years, enough to claim the mantle of the fastest-growing major economy?
For one, the central government has done a remarkably good job of maintaining fiscal prudence and macroeconomic stability. The central bank has complemented with policies to control inflation and maintain financial stability. Second, fortuitously, the global environment of fiscal accommodation in the post-pandemic era offered central and state governments an additional 2-4 percentage points of fiscal space each year, which it has utilised effectively to nearly double the capital expenditure as a share of GDP.
Third, the large size of the economy with its growing population and the addition of inputs means that there will always be a sustained pace of catch-up growth. The macroeconomic stability and tailwinds from a few reforms support this growth. Fourth, the central government’s use of industrial policy through its PLI scheme to catalyse domestic manufacturing has succeeded at least somewhat in breaking down the barriers to scale manufacturing in India. If it can be built upon, and this is by no means easy or assured, this can be an important contributor to broadening the economic base.
Fifth, there’s a small segment of the Indian economy, the one inhabited by its highly profitable corporates and its knowledge-based services sectors, that is undoubtedly dynamic. It contains a consumption class with high disposable incomes that’s collectively comparable to a middle-sized European economy. It has been among the most vibrant economic segments in the world economy for nearly two decades now. It encompasses sectors like the rapidly emerging Global Capabilities Centres (GCCs) of global corporations, which hold much promise. Given the size of the country, this small segment is large enough in absolute terms when compared to others. But this remains a sliver, and by their very nature localized in a handful of urban centres in the South and west of the country. Finally, in the absence of good data, there will always be questions about the actual growth rates.
Unfortunately, all these factors appear to have reached their limits in propping short periods of higher growth rates, and the present slowdown may only be an indication of an economy reverting to a growth rate that its capital base can support. With global economic conditions turning adverse, the domestic engines of growth must all be firing at full throttle to generate high growth rates. In their absence, the ongoing economic slowdown should not be a surprise.
If the explanation above is accepted, then it raises several concerns. What are the areas of concern that require attention?
It’s hard to argue against the view that India missed the great opportunity to capitalize on three decades of economic stability and growth and build its capital foundations. The economic liberalization and post-millennium economic and political stability provided the country the time to build the foundations for broad-based economic growth. It was also an opportune period of benign global economic conditions to develop its manufacturing capabilities and integrate itself with the global supply chains.
It can be argued that the country’s biggest failure has been in human and institutional capital formation, the basis for sustainable growth. Unfortunately, it has been unable to make meaningful investments in the quality and quantity of human capital formation. Even when there has been intent, central and state governments have struggled to execute. A combination of private sector practices, adoption of band-aid digital technology solutions, and extensive outsourcing of core activities of government to consulting firms and others, coupled with the general trend of demonization and disparaging of governments (and its personnel and activities) have eroded state capabilities and enfeebled the state.
State governments are the principals in both these endeavors, and any meaningful effort must involve their active ownership and engagement. Unfortunately, the increased confrontations and acrimony between the central and state governments on issues is a serious obstacle to these endeavors. Both the centre and state must walk together to stand any chance of making a meaningful dent in these problems.
India’s economic growth over the last few years has been mostly driven by inputs. There’s nothing undesirable or bad about this since that’s generally the case with catch-up growth that characterizes developing countries and has been a major factor in China’s spectacular economic growth. Further, since the pandemic, even as rural and urban consumption has flagged and private investments have stalled, public capital investments have emerged as the primary driver of economic growth. To the government’s credit, it has ensured macroeconomic stability and focused on the quality of capital expenditures.
But disappointingly, as discussed earlier, India’s much-hyped private sector has failed to step up in any meaningful way to create the foundations for sustained growth. The trends of business concentration and dominance of a few industrial groups across sectors work against broadening the industrial base. A revival of corporate investments, creation of good jobs, and sharing of the record profits with labour would have deepened and broadened the base of the consumption class, and set the stage for sustained high growth.
The stalling of structural transformation should not be seen as a temporary phenomenon. Instead, it should be viewed against the backdrop of global trends of premature de-industrialisation, expanding automation, the rise of Artificial Intelligence technologies, and the inherent limitations of the services sector in replacing manufacturing in the creation of productive jobs.
In this context, agriculture and related industries assume significance in livelihood formation and job creation. For long, despite half the population being dependent on it, public policy and public attitudes missed the plot by viewing agriculture through a subsistence and welfare lens, as a temporary holding sector awaiting the inevitable structural transformation, instead of positioning the sector as a source of dynamic and productive livelihoods and attractive incomes, and as important as manufacturing and services in accommodating those entering the workforce.
For all these reasons and more, the conditions for broad-based growth remain elusive.
As mentioned earlier, a small sliver in a continental-sized economy coupled with the standard inputs-based growth is large enough to sustain middling growth for a reasonable period. It’s most likely true that this segment of the economy has been one of the main growth drivers. But there are hard limits to how much it can contribute to growth, and it cannot be the foundation for sustained high growth rates. Worse still, if consumption in this sliver plateaus (as it will, since there are only so many cars and other purchases the well-off family can do), the catch-up growth factors flounder, and global conditions become adverse, there’s the risk of slipping into prolonged bad economic equilibriums. The base must expand considerably to be able to avoid this and realize sustained growth.
This slow expansion in the economic base has been coupled with evidently rising stress at the lower segments of the economy (which in this country forms the major share of the population). In less than four years, India has been subject to three large negative economic shocks in succession – demonetization, GST, and Covid 19 pandemic. A feature of all three shocks was its adverse impact on the informal and rural economies. These shocks also coincided with concerted efforts to shrink and formalize the informal economy. For a country where the poor people and rural areas largely inhabit the informal economy, it’s hard not to believe that the impacts of these shocks have been very significant.
Efforts to formalize the economy, while laudable, may also have gone overboard in pushing it too hard and too quickly. As experience from other countries and research shows, the formal sector’s share of the economy expands less by shifting the existing informal sector but by creating the conditions for the new growth to become formal. Besides, the belief that digital payments and capturing economic transactions can formalize an economy overlooks the several other important factors that contribute to informality.
The combination of the struggles on human capital and state capability fronts, economic growth confined to small slivers concentrated in the metropoles, and the unwitting (or misguided) neglect of the sector that employs half the population point to the narrow base of economic dynamism. Broadening the base is an essential requirement for sustained growth.
Amidst all this, state and central governments are faced with an inexorably rising trend of competitive populism that threatens to wreck the fiscal balance. Recalibrating the political economy incentives away from the likes of cash transfers towards productive expenditures is an essential imperative.
In conclusion, to aspire to emulate the Northeast Asian success and ensure sustained high growth rates, in addition to maintaining macroeconomic stability, investing in infrastructure, and improving ease of doing business, the state and central governments must prioritize efforts towards significantly improving the quality of human capital and building the capabilities of public systems to design policies and implement them effectively.
Economic policy must equally target productivity and dynamism in the manufacturing, services, and agriculture sectors. No country can attain sustained high growth by glossing over half its population and over two-fifths of its workforce. The importance of female workforce participation and agriculture productivity cannot be overstated. Finally, the private sector must step up to make capital investments, create good jobs, embrace innovation and significantly raise R&D expenditures, and prioritize exports.
The objective of these efforts must be to broaden and deepen the human, physical, financial, industrial, and institutional capital that would create the platform for sustained high growth. Dauntingly, the country must do all this amidst rising geo-political uncertainties, adverse global economic conditions, and the urgent need for climate change adaptation and mitigation.
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