Raghuram Rajan: Election results may determine India’s economic future

Labour flows out of the traditional agriculture sector as employment increases in low-skilled manufacturing.
Labour flows out of the traditional agriculture sector as employment increases in low-skilled manufacturing.

Summary

  • Will a factory-led development model work for India too? China’s manufacturing focus made it an export powerhouse, but India’s government has adopted a similar growth strategy under circumstances that seem far less favourable.

There is a buzz in India today—a sense of limitless possibilities. India has just overtaken its former colonial master, the UK, to become the world’s fifth-largest economy. If it maintains its current growth rate of 6-7% per year, it will soon overtake stagnant Japan and Germany to take over third place. 

But by 2050, India’s workforce will start shrinking, owing to demographic ageing. Growth will slow. That means India has only a narrow window in which to grow rich before it grows old: with per capita income of just $2,500, the economy must grow by 9% per year for the next quarter-century. That is an extremely difficult task, and the current Lok Sabha elections may well determine whether it remains possible at all.

Also read: Indian companies should reduce dependence on China, reiterates Jaishankar

The China model: In pursuit of rapid growth, the Indian government intends to follow a tested road map: the same path that Japan took in the immediate postwar decades and that China took after the death of Mao Zedong. During the first stage of the journey, labour flows out of the traditional agriculture sector as employment increases in low-skilled manufacturing—typically stitching garments or assembling components into electronic goods. This output is then exported to the developed world to capture the benefits of producing at scale.

Cheap labour helps compensate for a country’s other deficiencies, such as excessive bureaucracy, unreliable power (especially electricity), or poor roads. As firms profit from exports, they invest in equipment to make workers more productive, and as workers are paid more, they can afford better schooling and health care for themselves and their children. Tax revenues also grow, providing the resources to upgrade the country’s infrastructure.

The result is a virtuous cycle, because higher-skilled workers and better infrastructure enable firms to make more sophisticated, higher-value-added products. That is how China has moved from assembling components to producing world-leading electric vehicles (EVs) in just four decades. Unfortunately, the same strategy is unlikely to work for India today.

Why China surged ahead: It is no accident that India failed to join China in shifting its economy to export-oriented manufacturing, even though the two countries were similarly poor in the late 1970s, when China started on that road. Even low-skilled factory employment requires a minimum level of education and skills. At the time, many Chinese workers met this standard, whereas most Indian workers did not. Foreign employers found China and its cheap-but-capable workers more attractive.

Moreover, China’s factory workers acquired skills on the job and their education allowed them to pick up the basic accounting needed to launch their own small enterprises making products like screws and door handles. This explosion of smaller firms contributed immensely to Chinese growth.

China had other advantages, too. Despite the outward perception of centralized rule by the Communist Party of China, provincial and municipal bosses have wielded a great deal of power. Mayors, hoping to be promoted for generating growth, helped local firms navigate the country’s otherwise-stifling regulations, overriding a rule here and overlooking one there in the name of results. By contrast, Indian bureaucracy in the same period was neither decentralized nor incentivized to promote growth, so it instead became an additional burden on Indian business.

Finally, autocratic China could always favour manufacturing in ways that democratic India could not. For example, the Chinese government appropriated land for commercial purposes where necessary; pressured unions to limit wage demands even as labour productivity grew; paid depositors in state-owned banks minimal returns so that the funds could be lent out cheaply to firms; and kept its exchange rate undervalued to support local firms’ international competitiveness. In India, attempts to do any of the above would have met fierce democratic resistance.

Also read: India needs greater sophistication in manufacturing, says FM Nirmala Sitharaman

Wrong way: Nonetheless, the current Indian government wants to board the manufacturing bus. With many others looking to diversify away from producing in China, Indian economic policymakers see an opportunity to make up for lost time. Moreover, Indian infrastructure has improved markedly. Among other things, the country now boasts many world-class airports and ports, increased renewables capacity to bridge power deficits, and an excellent highway system. 

But impediments remain. Over the decade that the Narendra Modi administration has been in office, India’s garment exports have grown by less than 5%, while Bangladeshi and Vietnamese garment exports have grown by over 70%, such that their exports are now multiples of India’s. Recognizing these drawbacks, New Delhi has begun offering subsidies to incentivize production in India as well as raising tariffs on imports (like cellphones) to enhance the profits of manufacturers selling their wares in India’s large and now-protected market.

While it is still early days, one should be sceptical of this strategy. Production-linked subsidies might induce manufacturers to assemble in India, but those firms still will need to import most components. Moreover, margins will be small, because Indian workers now compete with modestly paid Bangladeshi and Vietnamese workers, not with well-paid workers in industrialized countries, as in the past. 

With little profit for firms to reinvest (and with less tax revenue, net of the subsidy) the virtuous circles needed to move India up the value chain will be much harder to achieve. Worse, even if the government were to scale up manufacturing, the world is not ready for another China-size export powerhouse. 

Also read: Will India overtake China to become world's economic heavyweight by 2028?

Given the widespread shift toward factory protectionism and growing concerns about environmental sustainability, the government’s emphasis on Chinese-style factory-led development seems incompatible with where the world is headed. ©2024/project syndicate

This is the first of a two-part series on India’s elections and its economy.

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