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Business News/ Opinion / Online Views/  How the Indian economy is losing competitiveness
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How the Indian economy is losing competitiveness

India now needs another round of economic reforms that will create the conditions for the next round of productivity gains

One reason why capital efficiency in India is deteriorating is because many investment projects have got stuck well after companies have built assets on the ground—the most well-known example is what has happened in the power sector: the lack of coal linkages has meant that power plants are unable to produce electricity. (the lack of coal linkages has meant that power plants are unable to produce electricity.)Premium
One reason why capital efficiency in India is deteriorating is because many investment projects have got stuck well after companies have built assets on the ground—the most well-known example is what has happened in the power sector: the lack of coal linkages has meant that power plants are unable to produce electricity.
(the lack of coal linkages has meant that power plants are unable to produce electricity.)

Mumbai: Is the Indian economy losing competitiveness? The answer can go a long way in explaining its possible trajectory in the coming years.

The portents are not good. The World Economic Forum (WEF) said in its latest global competitiveness report released in September that India had slipped to number 59 in its ranking of 144 countries, or down 10 places in three years. The International Monetary Fund (IMF) noted in its April report on the global economy that the growth in total factor productivity has been coming down since the end of the boom. Prime Minister Manmohan Singh’s economic advisory council has pointed out that the incremental capital-output ratio (ICOR)—a measure of economic efficiency favoured by Indian planners—has been going up in recent years.

Each of these measures requires some explanation. WEF defines competitiveness as the set of institutions, policies and factors that determine the level of productivity of a country. The total factor productivity used by IMF is one of the three drivers of economic growth according to standard economic models: capital, labour and productivity. The incremental capital-output ratio used by the economic advisory council calculates how much extra capital is needed to produce one additional unit of output; a rise in the ratio tells us that the productivity of capital is declining.

All three indicators are flashing amber—and that is a worry.

To understand why this is a worry, let us go back in time to the years before the advent of economic reforms. The planning era had helped India build an industrial base, but one that was very inefficient thanks to high levels of protection against imports as well as a lack of adequate domestic competition thanks to industrial licensing. An overvalued rupee did not help matters either.

Matters came to a head after the two oil price shocks: in 1973 and 1979. The import bill shot up but India did not have a competitive economy that could earn the dollars needed to pay for these imports. The road to the macroeconomic crisis of 1991 was paved. There were some tentative reforms in the 1980s that eased some of the constraints on the Indian economy, but it was only the radical reforms between 1991 and 1993 that transformed the situation.

There were bumps along the way, but the productivity gains in the first decade after reforms helped power the unprecedented economic boom during the first decade of the current century. To be sure, other factors also mattered—the synchronized global boom of those years and the rise in the national savings rate thanks to lower fiscal deficits. But the role played by rising productivity deserves more appreciation.

WEF says in its competitiveness report: “A more competitive economy is one that is likely to sustain growth." That is in line with what economists who have studied growth have said for long: an economy can grow for some time by using more inputs but the secret of sustained growth is higher productivity.

One of the best illustrations of this truth was during the Asian crisis of 1997. Paul Krugman wrote in a famous article in 1994 that the Asian economic miracle was not so miraculous after all. Growth in countries such as South Korea, Singapore and Thailand had been powered by intensive use of inputs, making it no different from other growth stories in previous decades. Krugman then pointed out that such growth could not be sustained unless the focus shifted from using more inputs to using inputs more productively. A few years later, what Krugman had predicted came true. Countries across East Asia tumbled into crisis (though Krugman had predicted a gradual slowdown rather than a spectacular implosion).

The falling productivity trend in India should be seen against this background. Be it the Indian economic crisis of 1991 or the Asian economic crisis of 1997, weak productivity growth was an important part of the narrative.

What is to be done? One set of solutions is administrative. For example, one reason why capital efficiency in India is deteriorating is because many investment projects have got stuck well after companies have built assets on the ground. The most well-known example is what has happened in the power sector: the lack of coal linkages has meant that power plants are unable to produce electricity. The new cabinet panel on investment hopes to iron out at least some of these administrative wrinkles.

But it is likely that the problem runs deeper. India has more or less exhausted the benefits to productivity that came from the economic reforms of 1991 and the subsequent corporate restructuring. The country now needs another round of economic reforms that will create the conditions for the next round of productivity gains and, hence, of higher economic growth. The goods and services tax that will help create a single Indian market is one such reform that needs to be pushed through.

India is now amid a structural slowdown. Its productivity growth is declining. Capital is being used less efficiently than before. These are not problems that can be solved by stimulus, be it lower interest rates or a higher fiscal deficit. What India needs is the next round of meaningful economic reforms.

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Published: 17 May 2013, 12:53 AM IST
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