There are several versions of India’s growth story. The most obvious one is the role of liberalization in fuelling the economy, by opening up trade to the rest of the world and removing stifling industrial controls. Another version emphasizes the preconditions that made liberalization work: public investment in education, infrastructure and institutions. A variant of the latter argues that key policy changes favoured existing big businesses rather than promoting true market competition. A different telling of the tale emphasizes entrepreneurship, changes in industrial structure and the rise of new firms in areas such as information technology (IT) and IT-enabled services.
Data-intensive analyses of India’s growth experience look at increases in the investment rate, in total factor productivity and at changes in the sectoral pattern of growth. At the other extreme are non-quantifiable factors: changes in attitudes of policymakers towards business, of business people towards profit opportunities, and every man and every woman towards their country and its future.
Perhaps there are elements of all of these factors in understanding India’s growth story. We can probably never get a definitive and comprehensive picture of what happened. Nevertheless, I like the story that emerges from a recent analysis by Kunal Sen. First, Sen suggests that once the outlier year of 1979 is omitted (when growth was a negative 5.2%), the acceleration in per capita gross domestic product (GDP) began in the mid-1970s, before the changes in attitudes towards business that have been highlighted by some economists and political scientists. This hypothesis is consistent with an institutional analysis by Baldev Raj Nayar, which describes policy changes in that period that could have supported faster growth.
Second, Sen identifies a steady increase in the rate of gross fixed investment since the 1970s, driven primarily by a “spectacular” increase in the rate of private sector equipment investment. Further, when Sen empirically examines the factors that determined growth in per capita GDP from 1955 to 2004, only the ratio of private sector equipment investment to GDP is significant. None of the other components of investment—the respective ratios of public sector investment in equipment, of investment in structures (public and private), and of changes in stocks, to GDP—matter.
So, an increase in a particular kind of investment mattered for growth. What explains this increase? The third key result emerges when Sen examines the determinants of private sector equipment investment. Now the story gets even more interesting. Total public investment as a ratio of GDP has been a significant determinant of the private-equipment-investment-to-GDP ratio. So has financial deepening, as measured by the ratio of private sector bank credit to GDP. And so has a fall in the relative price of equipment (triggered by changes in trade policy towards greater openness). These are the pillars of good government policy: public infrastructure, a robust financial sector, and getting prices right.
A fourth set of results relates to policy or attitudinal changes. Sen finds no evidence for any shift in private equipment investment in 1980-85 that might reflect the supposed emergence of a pro-business stance in the period. But there is a clearly significant effect of the 1991 reforms, shifting private equipment investment upwards.
Finally, private equipment investment in India lines up strongly with total factor productivity (TFP)—their correlation is almost perfect, at 0.96. This also fits with the theoretical rationale for the importance of private equipment investment in growth based on its positive spillovers to the rest of the economy. On the other hand, TFP is negatively correlated with the other main components of investment.
At the beginning of India’s growth acceleration, public investment was an important driver of the increase in private equipment investment, but more recently, the driving forces have been decreases in the relative price, and financial deepening. There may be a big picture lesson to be drawn from this pattern. If the public sector in India is currently unable to deliver positively in terms of its own role in investment, at least it can support financial deepening—a focus on financial sector reform makes a huge amount of sense in the context of the growth story told here. Also, trade and exchange rate policy do not have to be mercantilist, promoting export-led growth. There may be plenty of room for domestic spillovers if the relative price of equipment investment is kept attractive— this strategy does not require an undervalued exchange rate. On the other hand, cutting tariffs and tweaking the tax code to provide incentives for private equipment investment may have good growth payoffs. Maybe Sen’s growth story can help policymakers improve their focus.
Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Comment at email@example.com