In a speech earlier this year, the chairperson of the US Federal Reserve, Janet Yellen noted that one key reason behind the Fed’s dovish stance is the slow productivity growth in the US. Labour productivity, measured as the output of goods and services per worker or per hour of work has been increasing at a very slow pace in the US and other developed countries, especially since the global financial crash of 2008. Slow productivity growth implies slow long-run growth in potential output, and a lower neutral interest rate, which means there is no need for dramatic rate increases, Yellen argued.
Although productivity growth does not top the list of issues policymakers in India and other emerging markets talk about, productivity growth matters more for such economies than for the advanced world, since it is sustained productivity growth that can raise living standards over the long run in these countries: if workers produce more per hour, there is more of output and income to share.
A small difference in annual productivity growth can add up to a big difference in standards of living over a generation. As Yellen pointed out, with productivity growth of 2% a year, the average standard of living in an economy will double roughly every 35 years. That means that the very next generation will be significantly better off than the current one. But if productivity growth is slower, say at 1% a year, it will mean a doubling of the average standard of living only every 70 years.
Raising productivity is thus among the foremost challenges faced by a developing country. In fact, developing economies have an additional challenge: not only should they seek to raise productivity in different sectors, they should also ensure that labour moves into the most efficient sectors of the economy.
Developing economies are often characterized by “large productivity gaps between different parts of the economy”, which is indicative of inefficient allocation of labour and other resources among different sectors of the economy, a 2011 research paper by Margaret S. McMillan and Dani Rodrik, economists with Tufts University and Harvard University respectively, pointed out.
Simply moving labour and resources to the more productive sectors alone can ensure overall rise in productivity and economic growth. However, there is no reason to believe that the process is inevitable or automatic. Indeed, many African and Latin American countries saw labour moving in the “wrong” direction in response to globalisation, according to McMillan and Rodrik. They argue that while efficiency of many formal sector firms increased in response to globalization, it was also accompanied by wide-scale shedding of excess labour and also the shutting down of the less efficient firms.
Unfortunately, many of the displaced workers ended up moving back to the informal sector, which predictably is characterized by lower productivity. Thus, McMillan and Rodrik conclude that the changes post 1990 in Africa and Latin America have often been “productivity-reducing”.
However, India’s experience since 1990s has been much better with a shift in labour away from agriculture to more productive sectors of the economy, especially manufacturing.
In fact, growth in labour productivity in India since 1980s, when steps to open up the Indian economy were initiated, has been the fastest in the manufacturing sector, followed by services and agriculture.
However, recent data show that overall labour productivity in India has declined in recent years in line with other major economies of the world.
While a part of the apparent decline in productivity could be due to measurement issues (which often leads to a high degree of correlation between measured productivity and GDP growth), India should be wary of falling into the trap that has afflicted Africa and Latin America.
There are reasons to worry that the high headline productivity growth in manufacturing might fail to translate into economy-wide gains. Firstly, much of the recent increase in measured labour productivity, since 2000s, is attributable to labour-saving techniques and increasing capital intensity in certain sectors such as chemical products, industrial metals and metal products. Labour-intensive sectors such as textiles, leather goods and wood products have witnessed much lower productivity growth.
Secondly, the manufacturing sector is witnessing increasing “informalization”, which has taken two forms – a rising share of the unorganized sector in manufacturing employment, and rising informalization of the organized sector workforce because of a rising dependence on contractual works or temps, as a research paper by Bishwanath Goldar, professor at the Institute of Economic Growth (Delhi) and Suresh Chand Aggarwal, professor at the University of Delhi pointed out.
Even in some of the bright spots of Indian manufacturing such as the auto industry, new jobs have gone mostly to contract workers. While firms may have found an easy way to bypass India’s labour laws by hiring such workers, and it may even boost aggregate employment in the short term, over the long run this trend can hurt productivity growth as the finance ministry pointed out in its Economic Survey last year.
Research shows that contract workers are at a disadvantage in picking up skills that might be firm-specific, either owing to their relatively shorter stay in any organization or lack of motivation.
Given that the skill-biased technological change over the past two decades was not accompanied by a significant increase in skilled workers, the productivity gains from liberalization, aided by liberal imports of capital and technology, have accrued only to a small slice of India’s workforce, as an earlier Plain Facts column pointed out.
The real challenge of “Make in India” is thus to create a large number of high-productivity jobs in labour-intensive sectors. With China attempting to rebalance its economy and lower its dependence on exports, there is an opportunity for India to step in, and carve out a space for manufacturing labour-intensive products for the world.
Several labour-intensive sectors in India are now dominated by small unorganized firms, and these firms are unlikely to propel productivity growth or make India-made products globally competitive. Unless organized firms (which have much higher productivity levels) are able to take the lead in the coming years, India is unlikely to witness a broad-based productivity surge which can raise living standards of Indians quickly over the next couple of decades.