Is India back? the race between hardware and software

ARVIND SUBRAMANIAN and JOSH FELMAN

 

FOR nearly a decade in the new millennium, India was the world’s fastest growing economy, outpacing even China. The venerable American media institution, National Public Radio (NPR) even coined a catchphrase – ‘the world’s fastest growing, free-market, democracy’ – as its way of encapsulating the world’s admiration, even astonishment, as India seemed to vault effortlessly from a nation mired in poverty into a modern high-tech, car owning middle class society. India, it seemed, was poised to be a global player, perhaps eventually a global superpower.

Analysts accordingly dehyphenated India from Pakistan and began to link it instead to China. Some even spoke of an interlinked Chindia, with China as the world’s factory and India its information technology (IT) back office. For a brief shining moment, this vision even seemed to be materializing, as companies such as Infosys, Tata Consultancy, and Wipro invaded the global market, its educated programmers writing software for the world’s largest companies.

But then the Global Financial Crisis (GFC) of 2008 intervened, changing the growth trajectory of all emerging markets but India’s especially so. India’s three-decade long structural transformation stopped, then stood still for an entire decade, as the initial shock was compounded by poor economic management and then by the Covid pandemic.

After a decade of stagnation, markets are now sensing that India is on the move again. A Bloomberg article asked if India could finally be the destination for investment fleeing China. India’s stock market is soaring. And foreign investors are pouring money into the country’s ‘digitech’ startups, partly because global finance is cheap, but mainly because India has a unique combination of software skills, dynamic entrepreneurs, and a large domestic market. Indeed, a new unicorn (startup valued at more than $1 billion) seems to appear every month, in finance, payments, tourism, education, entertainment, and cloud computing. Altogether, there are now 100 such unicorns, more than any other country except the US and China.

What explains this resurgence of market optimism? Two main factors. First, notwithstanding the recent policy reversal on the farm sector, the current BJP government has embraced market reforms, illustrated most prominently by India’s first privatization in two decades – the sale of Air India. After 68 years of maladroit public ownership, the national carrier has been sent back to its original owner, the Tata group, which aims to restore it to its previous glory. Ambitious reforms included corporate tax cuts and others are in the pipeline, including plans to monetize other public sector assets and clean up the arcane and archaic labour laws.

 

 

The second basis for optimism is the government’s success in strengthening the ‘hardware’ of the economy. The road and rail and road networks have been expanded, with some major new highways and the Delhi-Mumbai freight corridor nearing completion, alleviating India’s most obvious constraint on growth. At the same time, important digital infrastructure has also been built. A non-proprietary digital platform – the Unified Payments Interface (UPI) – has been established, creating an ecosphere that has allowed digital companies to innovate and the government to deliver cash to India’s poor.

Perhaps the most important improvement in hardware – certainly the economic bedrock of Prime Minister Narendra Modi’s political success – has been a distinctive approach to redistributive development, which could be termed a ‘New Welfarism’. This approach focuses not on supplying public goods such as health and education, as most governments around the world have done – and which has proved exceptionally difficult in India. Instead, it has entailed the subsidized public provision of essential, and essentially private, goods and services normally provided by the private sector, such as bank accounts, cooking gas, toilets, electricity, housing, and more recently water and just plain cash.

Some of the claims of this New Welfarism, for example that India is completely free of open defecation, are over-hyped; and progress in some areas could stall through complacency, but the achievements are real and evident. For example, according to the latest data from the National Family Health Survey (NFHS), 98% of all households now have access to electricity, nearly 70% to improved sanitation, and 60% to clean cooking fuel, while about 80% of all women have bank or savings accounts that they report as being able to use themselves.India now provides direct benefit transfers of about a trillion rupees every year.

 

 

Despite the market buzz, the public is much more pessimistic. According to the central bank’s consumer confidence index, 75% of those questioned in June 2021 believed
that economic conditions have deteriorated, the worst assessment in the history of the survey. Disaffection is also manifest in politics, as the confidence that all will gain from the bounties of growth has given way to a sense of ‘zero-sumness’, the belief that one group can gain only at the expense of another.

There are several worrisome examples. The Centre and states have been bickering for more than a year over the sharing of revenues from the Goods and Services Tax (GST). Several states have been imposing ‘jobs for locals only’ requirements, a direct challenge to the notion that India is and should be a common labour market. There has also been a revival of the politics of reservation. All these disputes, all this pessimism and a sense of zero-sumness, have a common economic root, in the dramatic growth slowdown of the past decade.

 

 

Ever since the GFC, India has been struggling to deal with thelending and investment excesses of the previous decade. Successive governments have launched initiative after initiative, which have gradually ameliorated but ultimately failed to resolve the problems. As a result, over-indebted firms have remained too financially feeble to invest, while banks with impaired balance sheets have remained reluctant to lend. And with investment and exports remaining hobbled, dynamism has slowly leached out of the economy.

New research shows that the economy has suffered from more than just weak growth. The employment rate has declined steadily, as has the already low share of the workforce in manufacturing – the phenomenon of ‘premature deindustrialization’. Progress in improving child health outcomes such as stunting, as well as reducing diseases such as anemia and acute respiratory illnesses, has slowed since the GFC after decades of steady improvement.

And then came Covid, extracting a devastating health, human, and economic toll.  India’s infection rate is well over 70%, amongst the highest in the world, leading to excess deaths somewhere between 2.5 and 4.5 million, according to a number of studies by academics. Many of those who survived, did so to find their lives blighted: heads of many families have suffered immense medical bills, while for 1½ years children were not able to go to school. In a country where learning outcomes are already modest, children’s futures have been rendered bleak.

As Covid spread, the economy withered, shrinking by more than 7% last fiscal year, the worst performance among major developing countries. Although large enterprises seem to have weathered the shock, small- and medium-sized businesses, weak from the 2016 de-monetization and the 2017 introduction of a complex GST,were sent reeling. Perhaps the most telling statistic for an economy with an aspiring, upwardly mobile middle class is car sales: the number of cars sold in 2020 was the same as in 2012: Even the latest data for GDP and industrial production shows that nearly two years into the pandemic, the economy is barely at pre-Covid levels.

Recognizing that the economy needs to be rebooted, the government has adopted a set of strategies to restart the twin engines of growth: exports and investment. The question: is will they work?

 

 

An historic opportunity has opened for India, as international firms are seeking to diversify their production away from China. Since the GFC, China has given up global market share in labour-intensive goods to the tune of about $150 billion. But so far India has been able to capture no more than 10% of that opportunity. The government is determined to seize a far greater share, launching a new industrial policy, Atmanirbhar Bharat. This three-pronged strategy comprises a return to subsidies, protectionism, and staying out of regional trade agreements, especially in Asia.

The subsidies have taken the form of production-linked incentives (PLIs), offered to domestic and foreign firms that reach specified targets in 13 sectors, including cellphones, renewables, automotive, electronics, pharmaceuticals and clothing. These subsidies could cost the government about 1% of GDP over five years.

As a further spur to domestic production, especially in favoured sectors, the government has reversed a three decade-long consensus and started increasing import tariffs. Since 2014, there have been about 3,200 tariff increases, affecting about 70% of total imports. As a result, the average tariff rate has increased from 13% to nearly 18%, pushing it well beyond the average rate in East Asian countries.

 

 

Meanwhile, India has halted its efforts to join regional trading arrangements. Between 2004 and 2014, India signed 11 preferential/free trade agreements. But none have been signed thereafter. In particular, India decided not to join the Regional Comprehensive Economic Partnership, a pact that covers nearly all Asian countries, including China, Japan, Korea and ASEAN, as well as Australia and New Zealand. Freetrade nego-tiations with the European Union have made little progress. And even as India stays away, China is actively integrating with its Asian and Pacific trade partners.

Will this strategy work? It is doubtful. After all, India has seen this movie before: it is a modern variant of the pre-1991 strategy, which was abandoned after India had fallen far behind its more market oriented Asian competitors. The new industrial policy, the ‘subsidy raj’, carries all the risks of the old ‘licence-quota-permit raj’, namely difficulty of enforcement, arbitrary decision-making, and the difficulty of exiting from a system of entitlements.

More to the point, the strategy fails to address the country’s pressing needs. India remains a young country, with large numbers of low-skilled workers looking for gainful employment in sectors that will provide them with a reasonable and growing wage. To satisfy their aspirations, India needs to follow the Asian recipe of boosting labour-intensive exports. But the PLIs focus instead on technology and capital-intensive sectors like cellphones, which will provide relatively few jobs for the bulk of the population.

Nor is the strategy likely to ach-ieve its objective of attracting many manufacturers to relocate from China. After all, the protectionist strategy will make it difficult for firms to access the inexpensive, high-quality imported inputs on which modern production depends. And staying out of Asia’s most comprehensive trade agreement means that India’s exports will face a disadvantage in the world’s most dynamic markets. So, at a time when India has been given an historic opportunity, when it finally has a chance to integrate its economy into global supply chains, it is moving in the opposite direction.

 

 

Acutely aware of the need to revive private investment, the government has taken a series of decisions to improve the investment climate. A decade-old law that taxed foreign companies retroactively has been reversed. Steps (albeit belated and partial) have been taken to relieve the heavy taxes imposed on the telecommunications sector. And as mentioned subsidies have been introduced to encourage firms to expand production. But perhaps the most distinctive aspect of the strategy, reminiscent of Korea and Japan several decades earlier, is to promote national champions. It is hard to know if this policy is explicit or inadvertent. But whatever the precise reason, certain domestic firms have prospered mightily over the past decade, especially Reliance Industries and the Adani Group.

The arguments in favour of creating national champions are well known. They can become big and achieve economies of scale, create networks and build infrastructure that provides national benefits. To some extent, this has already happened: the Jio group under Mukesh Ambani has democratized telecommunications, rolling out a low-cost 4G cellphone network that has given hundreds of millions of Indians access to the internet for the first time.

 

 

At the same time, there are reasons for concern. The private sector – and capitalism generally – evokes feelings of deep ambivalence. After all, it still bears the stigma of having been midwifed under the license-permit raj, an era characterized by corruption. Some of the private sector’s stigma was cleansed by the 1990s boom in information technology, which developed by virtue of its distance from, rather than proximity to, government. But then came the infrastructure boom of the mid-to-late 2000s, when public resources – land, coal, telecommunications spectrum – were captured by private firms under the previous government’s ‘rent raj’. And now some recent regulatory decisions – notably in telecoms and power – have favoured certain domestic groups. This is Stigmatized Capitalism, the 2A Variant.

This variant poses considerable risk, since it could undermine public support for market based reforms and capitalism itself. Indeed, it already has. There was intense resistance to the government’s agricultural reforms – even though they were supported by most economists – because farmers suspected they were likely to benefit big corporates at their expense. So, in the end, the government had to withdraw the measures.

It is true that the public’s concerns were ultimately attenuated by economic success in Korea and Japan. But success is unlikely to be the outcome in India.For a start, there are vast differences in the economic setting. The chaebol and zaibatsu generally operated in tradable sectors where they had to demonstrate efficiency by competing globally. But the 2As operate mostly in infrastructure sectors that are heavily shaped by government regulation. As such it will always be unclear whether they have thrived because they are efficient or merely because they have secured help from the government.

More immediately, the policy has undermined the objective of improving the investment climate. After all, for every favoured firm that has been encouraged to expand, many other firms have been discouraged, out of fear that they will not be able to compete with the national champions. Even as Reliance Jio was expanding rapidly, the financial positions of VodafoneIdea and Airtel were eroding. So, they are no longer strong enough to invest the huge sums needed to shift India’s cellphone system rapidly to 5G. Similarly, the plans of Walmart and the Tata group to develop their online retail platforms have been dashed by a planned change in regulations, while Amazon has been a victim in the physical retail space.

 

 

Beyond the specific problems caused by favouritism to national champions lies a broader problem in the economic framework, the country’s‘software’. The private sector will invest on a large scale only when it is confident in the future, not only in the opportunities that exist but also in the policy approach of the government. They need to believe that if a policy commitment is made, that it will be honoured; that when the government owes a supplier, the bill will be paid. Most of all, they need to believe that the government policies are sound and will continue to be sound.

But India is plagued by serious software defects, arising from problems that traverse the entire sequence of the policy-making process, from planning to implementation. There are problems with the even-handedness of decisions, data integrity and access, statecraft, policy consistency, and rule of law. The problems of even-handedness (the 2A issue) have already been discussed. Consider the other elements.

 

 

Over the past few years serious doubts have arisen about the quality of official data. In some cases, data reports have not been published or have been released and then withdrawn. The most recent budget arrested a growing trend toward off-balance sheet recording of expenditures, but there is still some way to go before the accounts provide a clear picture of the overall fiscal position. During the pandemic, scientists repeatedly asked the government to release the data it had collected. But very little data was released. With such inadequate data, how can anyone – in or out of government – be confident that good decisions are being taken?

Once a policy is formulated, statecraft is needed to gain support of the stakeholders, the groups that will be materially affected by the measure. A splendid example of this process at work was the passage of the GST, which was possible only because the government was able to win over opposition parties and reluctant states. Compromises had to be struck, carrots dangled, and sticks wielded.

Since then, however, state craft seems to have gone missing, especially in Centre-state relations. For example, the Centre formulated the farm reforms and passed them into law without much consultation with the states. Similarly, it formulated the initial response to the pandemic almost entirely on its own.

This lack of statecraft is a major problem because nearly every major policy issue in India today – power, agriculture, taxes, welfare schemes, pandemics – requires joint action by the Centre and states. If decisions are taken unilaterally, policy making can become trapped in a vicious cycle, in which a lack of trust on the part of the states discourages them from implementing the policy properly, thereby eroding the Centre’s trust and discouraging it from consulting with the states on the next policy measure.

 

 

Once consensus is achieved and a major policy initiative launched, governments need to ensure that subsequent measures remain in line with the broad strategic objective. All too often this does not occur. For example, plans to improve farm income have been undercut by decisions to ban key exports and limit the amount of food stocks that private firms can hold, which depress prices received by farmers. The intention to widen the tax base was set back when in 2019 the income tax threshold was raised dramatically, removing about three-quarters of taxpayers from the tax net.

All governments must beat policy retreats from time to time. But systematic policy inconsistency means that firms cannot count on the economic framework: if they invest today based on current rules, they will run into difficulty if the rules change a year or two down the line. So, to be careful, they hold back their investments.

Even when a sensible policy is formulated and sold to the public, policy implementation has proved a major difficulty. It’s not just that there has been a large gap between intentions and realities; it’s that enforcement of rules on the private sector and fulfilment of contracts with private firms have been decidedly uneven and sometimes punitive. This is problematic, because the sanctity of contracts and robust institutions – key components of the ‘rule of law’ – are critically important for growth. Recent development literature finds that when contracts cannot be enforced firms will be reluctant to undertake major infrastructure projects or large-scale investments in manufacturing; it is just too risky. Instead, they will focus on smaller scale activities, such as trading. As indeed has been happening in India.

 

 

As long as Covid continues to wane, the coming year should be a good one for India, as the economy recovers the ground it has lost over the past two years. But then what? Optimists hope that India is on the cusp of another boom. But restarting the long-dormant engines of exports and investments will not be easy, particularly when the government’s strategies seem inadequate to the
task. Without doubt, India will be propelled forward by steady improvements to the nation’s hardware: its physical and digital infrastructure, its New Welfarism. But it will be pulled back by the defects in its policy software. And in this tug of war, the betting must be that the software is likely to prove decisive. Unless the country can fundamentally improve its policy-making process investors will remain distrustful, unwilling to make the bold investments needed to alter the country’s economic course. They were fooled once, in the early part of the millennium. And they won’t be fooled again.

Compare India’s situation to that of China. One noticeable difference works in India’s favour. The Chinese ‘hardware’ model, based on high rates of investment in infrastructure and housing, has now run its course. In contrast, India’s hardware model has many years yet to run.

But there are also potential similarities when it comes to software. Both countries have defective political-economic software – and in some respects the defects seem to be getting worse. China is undermining its economic software through punitive state actions that will damage entrepreneurship, creativity, and innovation, especially in sectors where Chinese firms were at the global cutting edge. Politically, repression and the clampdown on freedoms is proceeding as rapidly as the apparatus and technology for enforcing them is improving in the hands of the sophisticated Chinese state.

 

 

Meanwhile, in India majoritarianism and illiberalism could affect social stability and peace, as well as the quality of institutions such as the judiciary, the media, and regulatory agencies. Without doubt, there have been long spells of prosperity under illiberal regimes. But divisive politics
will eventually exact economic costs by affecting the climate of trust between the state and investors, the state and its citizens, and in federal India, between the central government and the states. We also cannot know the medium-term economic and political consequences of large minorities feeling systematically excluded.

If this climate deteriorates, regaining lost economic dynamism will prove the least of India’s problems. In that case, all three achievements in NPR’s catchphrase – ‘fastest-growing, free-market, democracy’ – risk being set back.