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The Promise of India: The Challenges Ahead

In May 2004, the Congress Party defeated the incumbent Bharatiya Janata Party (BJP) in India’s national elections. The defeat showed that while most of the U.S. discussion on India has been focused on off-shoring, India and other developing countries are facing their own economic challenges at home. The Congress Party won campaigning on a fairly simple message — that the economic reforms promoted by the BJP-led government had not reached everyone, especially those in the villages and the poor. While this rallying cry made a good campaign slogan, there is a real question about how the Congress Party itself will balance the challenge of continuing growth-inducing economic reforms while at the same time showing tangible improvements in the lives of those not yet reaping the benefits of economic growth.

The Congress Party, led by the very competent Manmohan Singh, knows that it needs to continue with the reforms that the party itself set in motion in the 1990s. Without them, the strong economic growth that India has experienced in recent years will slow. In the long run, the benefits of economic growth will help alleviate poverty in India as all incomes rise, but at the same time, it is very likely that inequality will also continue to grow. To complicate matters, Congress will be pressured to slow the pace of reforms given its campaign rhetoric and the need to compromise with its left-leaning coalition partners, who are wary of economic reform and believe that the government should remain a major part of the economy.

Moving forward, the Congress Party faces several challenges. It needs to continue to implement the macro economic reforms that reduce the size of the government, create incentives for greater domestic private sector investment, and integrate India more fully into the global economy. At the same time, it needs to meet its promise of improving the lives of the poor by providing better services, increasing access to health care and education, and creating jobs for the rich and poor alike, while constrained by a fiscal budget that is already stretched to the limit. Politically, in order to achieve this tremendous potential, Congress will need to create a stable government that can convince the public that economic reforms have and will continue to bring prosperity to Indian citizens from all walks of life.

Before addressing India’s current economic outlook, it is important to look at its past history. After achieving independence from Britain in 1947, India, run by the Congress party, embarked upon an economic strategy based on socialism, self-sufficiency, and Soviet-style central planning. It pursued an “import-substitution” industrialization strategy from 1950 onwards, by which it restricted imports to protect its own manufactures from foreign competition, maintain self-sufficiency, and industrialize its economy. By 1980, India’s share of international trade had fallen from 2.5 percent at independence to less than 0.5 percent. Its annual economic growth rates averaged a mere 3.6 percent from 1950-1980 while the population grew at an average annual rate of 3.1 percent, leaving per capita income growth more or less flat.

The Congress Party ruled India for 45 out of its first 50 years of independence. It was under the watch of Rajiv Gandhi (1984–1989) that the Congress-led government began a process of liberalizing the Indian economy. Gandhi’s policies, however, did little to eradicate or diminish poverty and the vast inequities of power and wealth which are to be found in Indian society. His period in office was marred by scandals and allegations of corruption on a scale so huge that he undoubtedly lost the election of 1989 partly on account of the public perception. He was assassinated in 1991 while campaigning to regain office. When the BJP led government won the national elections 1999, it was the first government in 6 years to maintain power for its full five-year term, which gave them the ability to significantly push the economic reform agenda.

Surprisingly, the BJP-led government lost the May elections despite an average annual economic growth rate of over 6 percent during their tenure (and a 10.4 percent growth rate last quarter), increased foreign investment, and the highest level of reserves during their leadership. Both parties, Congress and the BJP, focused heavily on economic reforms during the elections; Congress, however, focused on the need to include the poor in the booming and increasingly market-based economy. The irony is that the criticism that reforms had not directly benefited the poorer classes was precisely the reason Congress lost the election to the NDA (and BJP) in 1999. Since the poor in India are the group that comes out to vote, they have demonstrated themselves as an important constituency.

The economic reforms have led India’s quasi-socialist, closed economy towards a more market-based economy and have been credited for much of India’s recent economic success. Over the last twenty years, governments led by both the BJP and Congress have moved to lower trade barriers, lessened restrictions on foreign direct investment (FDI), and disinvested the government from many of its inefficient, publicly owned enterprises.

The reforms, which began in the 1980s, have been pursued with particular intensity since 1991, when India was forced to take out a loan from the IMF that was conditional upon the implementation of pro-market, pro-globalization reforms in India. The Congress Party, which headed India’s government at the time, pursued economic liberalization with even more fervor than mandated by the terms of the IMF loan. Then Finance Minister and now Prime Minister Manmohan Singh, an Oxford-educated economist, played a particularly vital role in pressing the need for reform.

Under Singh’s guidance, and later that of the BJP, the maximum tariff rate was gradually lowered from 400 percent in 1991 to 40 percent in 1998, where it stands today. The average tariff rate was reduced to less than 25 percent, down from 60 percent in 1991. Import licensing restrictions, which denied many foreign-produced goods access to the Indian market, were completely abolished by 2001. The Indian government has also disinvested itself from many of its publicly held enterprises and has become much more welcoming of foreign direct investment (FDI), allowing foreign investors to purchase larger shares of equity in Indian firms.[1]

The net results of these reforms have been dramatic= The economy has grown at an average rate of 5.9 percent per year since 1991, accelerating to its fastest rate yet, 10.4 percent, in the first quarter of 2004. India’s exports and imports as a share of GDP increased from 17.2 percent in 1991 to 30.5 percent in 2003. The reforms have spurred significant investment. In the nine years from 1981 to 1990, net FDI to India was increasingly minimally by $130 million per year. After the reforms, net FDI slowly accelerated, increasing by an average of $800 million per year from 1991 to 1995. Since 1996, it has expanded by an average of $2.9 billion per year.

The medium-term outlook for India’s economy is “buoyant” according to the Asian Development Bank, which expects growth to average around 7.4 percent per year over the next two years. Most promising are the results of an October 2003 study by Goldman Sachs that lists India as the fastest growing economy over the next 45 years, averaging 5 percent growth per year through 2050.[2] Importantly, however, the study highlights that its results are conditional upon the continuation and acceleration of economic reforms as had been promoted by the BJP-led government, placing the Congress Party in a delicate position.

As the analysis shows, India cannot afford to rest despite this excellent progress; as its population continues to grow, it needs to continue reforms to ensure sustained growth for all segments of the population. This will be particularly challenging, as it has a high fiscal deficit, currently around 11 percent of GDP, constraining any new spending. Barriers to trade and investment are still high (both internal and external), even though they have been lowered significantly. India currently ranks second in terms of high tariff zones in the world. FDI, although increasing, is still far lower than that of other emerging market economies due to India’s more restrictive policies limiting foreign equity ownership and its poor infrastructure. Domestically, there needs to be greater investment in a more efficient regulatory and administrative framework with greater transparency and ease of use. Finally, the government needs to privatize more industries, especially those continuing to drain resources, which should also help the fiscal deficit.

The economic reform agenda was not, and is still not, popular among the public. Notably, Indian citizens voted against Congress in the 1996 elections in backlash to the reforms, just as they rejected the BJP in this year’s national elections. Public support for the reforms has been limited because most of the tangible short-term benefits of liberalization seem to go to the middle class rather than to the poorest, and in India, the poor are the ones who turn out come election time. But in pursuing economic reform, India should keep in mind a quote taken from Stanley Fisher: “The pro-market pro-globalization approach is the worst economic policy, except for all the others that have been tried.”

There is no doubt that the poverty levels in India are staggering. India is home to the world’s largest population living on less than $1 a day, considered to be the international standard for poverty. Congress’ campaign promise to address the plights of the poor is laudable and necessary, but it is important to note that these policies do not have to come at the expense of economic reforms. In fact, the two can be accomplished together if the new government is willing to make some tough and smart decisions.

The first point to make is that economic growth and poverty reduction go hand in hand. While the path to poverty reduction is by no means completely understood, economic studies have shown that there is a strong relationship between overall income growth and growth in the income of the poor. And while increasing inequality can be and often is a consequence of economic growth, this does not mean that the incomes of the poor are going down while the incomes of rich are getting larger. In fact, in some cases, the poor are getting richer but the rich are getting richer faster. Nonetheless, the gap is increasing.

The Indian government needs to implement an effective poverty reduction strategy which focuses on some key tangible benefits for the poor, which are also good for the economy. There needs to be a greater focus on education – making the current system more effective, providing for better quality of education in the rural areas, and ensuring greater access to the poor as well as the rich. Similarly on health – a healthier population is also more productive, thus, the system needs to provide affordable health care to all segments, not only to those in the upper strata of society. Health care expenditures by the government are particularly inadequate, at less than 1 percent of GDP.[3] Labor laws and regulations should be modified to ensure that the poor can be employed in the private economy and sustain themselves rather than relying on handouts from the government. At the same time, some labor laws should be better enforced, especially those affecting child labor and sweatshop labor.

On the business side, the government needs to allow companies the freedom to make decisions that will create opportunities for investment and expansion while at the same time providing effective regulation. According to the World Bank’s “Doing Business” database, starting a business in India is more onerous than in many other countries. According to the Bank, it would take an Indian business 88 days to start a business placing it behind China (46 days), Malaysia (31 days), Pakistan (22 days). The cost is also burdensome – 50 percent of GNI (Gross National Income), which is more than in Peru (25 percent), Mexico (19 percent) and China (14 percent). In fact, the regulatory and administrative burdens are higher that in more developing and emerging market economies, particularly at the state level.[4]

To the extent that the government can meaningfully help in the battle against poverty, it should focus its efforts on addressing social issues that cannot be adequately handled by the private sector. These include providing access to education and health care as mentioned above. In addition, public funds can be used to improve infrastructure, including roads and access to clean water, especially in the rural areas. The government has the comparative advantage in addressing the larger infrastructure needs, although the private sector can certainly do much of the work. All of these can have a direct impact in rural areas and in the slums. Much of the responsibility lies with the state governments. This means that the national government needs to provide the adequate resources and sufficiently hold state governments accountable for outcomes in education and healthcare, and ensure that all parts of the population, especially the rural and the poor, have access to the benefits.

India’s greatest challenge is financing new projects. Its budget deficit is already 11 percent of GDP. India’s new leaders need to take a realistic look at this situation and make some difficult decisions about how to reduce the cost burden of the government and free up the necessary funds for its social agenda, not just play a shell game.

A first goal should be to ensure that funds that are already available for rural development and services are used as effectively as possible. This means that the central government needs to assess all of its subsidy programs, most of which are very inefficient. Then, both the central and state governments need to create more transparent methods of government transfers and give communities an opportunity to decide their priorities, thus empowering the communities while also giving them more responsibility for their own well-being. Finally, the central government needs to link assistance to states based on performance. As in the United States, the national government sets the macroeconomic policy and provides national security, while most development initiatives occur at the state level. Those state governments that have effectively addressed corruption and transparency and offered a more conducive environment for growth (such as Andhra Pradesh, Maharastra, and Gujarat) have achieved higher state GDP growth rates (5.2 percent, 8 percent, and 8.1 percent respectively) than those that have not. State governments that fall in the latter category, such as Bihar and Uttar Pradesh, have growth rates lagging at 2.8 percent and 3.6 percent respectively.[5] If these disparities are not adequately addressed, the gap between the rich and poor states will continue to grow.

For poverty programs needing additional funding, the focus should be on cutting unnecessary costs elsewhere in the budget both at the central and state levels. The central government’s largest expenditure is its debt service (28.5 percent of total expenditures in the 2003-2004 budget) and at the state levels, it is largely the salaries of a bloated bureaucracy and the funding of public sector enterprises (PSEs). There are 1071 PSEs in India in various states, of which only 247 make a profit. Privatizing these PSEs would not yield significant resources, but it would eliminate consistently recurring losses currently absorbed by the state and national governments. [6] The national government can continue transfering employment to the private sector, fueling the move towards privatization while also reducing its own overall cost burdens. It can also sell the companies that it owns and operates, bringing in added revenues with which to fund social programs and releasing government resources for other domestic priorities.

Most importantly, the government must not fall into the trap of believing that simply throwing money at the poor in the form of subsidies and inefficient, unnecessary employment is a real and viable solution to poverty. History has shown that it is not. These are just a few of many choices Congress will have to make in the coming months. The signals that it sends will have a great impact on both domestic and international investors, so it will have to make the trade-offs wisely.

Once it decides on an economic course, giving its policies political leg will provide a further challenge for Congress. First, Congress’s coalition partners are made up from the country’s socialist and communist parties. Second, Congress will also hold a smaller majority within its coalition than did the BJP, with 138 seats out of the coalition’s 217. In addition, it will have to appeal to the Left Parties, which are supporting Congress from outside the coalition and hold 58 seats. Because these powerful partners are wary of economic reform, passing reform legislation may become difficult. The Left Parties, for example, have made it clear that they are in favor of maintaining government stakes in companies, especially those that have been profitable, which are the very companies private investors seek. This could have an impact on the on the privatization program which could spook investors and continue to stretch the government budget.

However, the Congress Party’s historical stance on economic reform and its commitment to continue with it are encouraging, especially as it has confirmed Singh, who is considered the father of India’s economic reforms, as prime minister. In addition to adding credibility to the party’s ability to pursue reform, Singh may be able to articulate more persuasively the benefits of reform to those who remain skeptical.

If, ultimately, the Congress Party’s alliance with its coalition partners stands in the way of pursuing the economic reforms that Congress clearly supports, then it should perhaps give thought to the idea of a Congress-BJP coalition. What a powerful statement of democracy it would be if the two largest parties in parliament could join together for a common purpose so vital to pushing India towards its potential for greatness.

Sonal Shah is the Associate Director for Economic and Foreign Policy at the Center for American Progress. Radha Chaurushiya is an economic policy analyst at the Center for American Progress.

  1. Panagariya, A. (2004) “India in the 1980s and 1990s: A Triumph of Reforms”, IMF Working Paper, Research Department, March 2004
  2. Wilson, D. and R. Purushothaman (2003) “Dreaming with the BRICs: Path to 2050”, Goldman Sachs Global Economic Paper No. 99, October 1, 2003
  3. Human Development Indicators 2003
  4. Sustaining India’s Services Revolution, The World Bank, June 2004
  5. Ahluwalia, MS, State Level Performance Under Economic Reforms In India, Stanford University’s Center for Research on Economic Development and Policy Reform, Working paper 96.
  6. Ahluwalia, MS, State Level Performance Under Economic Reforms In India, Stanford University’s Center for Research on Economic Development and Policy Reform, Working paper 96.

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Authors

Sonal Shah

Senior Fellow

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