india's long-term growth experience

FOREWORD

1

India’s Long-Term Growth

Experience

INDIA’S LONG-TERM GROWTH EXPERIENCE

2

FOREWORD

3

India’s Long-Term Growth

Experience

Lessons and Prospects

Sadiq Ahmed

THE WORLD BANK


4

© 2007 The International Bank for Reconstruction and Development/The World Bank, 1818 H Street,NW, Washington, DC 20433

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Library of Congress Cataloging-in-Publication Data

Ahmed, Sadiq.India’s long-term growth experience : lessons and prospects / Sadiq Ahmed.

p. cm.Includes bibliographical references and index.1. India—Economic policy—1980– 2. India—Economic conditions—1980– 3. Structural

adjustment (Economic policy)—India I. Title.

HC435.2.A7435 338.954—dc22 2007 2007003522

ISBN: 978-0-7619-3605-3 (Hb) 978-81-7829-768-2 (India-Hb)

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FOREWORD

5

Contents

Acknowledgments 6Foreword 7

1. India’s Emerging Global Significance:Can Growth Accelerate Further? 11

2. Evolution of India’s Long-Term Growth 17Trend in Total and per Capita GDP Growth: 1950–2004 17Sectoral Composition of Growth 20Labor Force, Employment, and Real Wages 23Regional Pattern of Growth: State-Specific GDP 28Growth, Poverty, and Human Development 31

3. Determinants of Growth: Growth Accounting 35Savings and Investment 35Total Factor Productivity 36Growth Accounting: A Summing Up 37

4. Policy Framework for Supporting Growth 41Macroeconomic Stability 43Policies for Improving Incentives for Private Investment 57Reforms at the State Level 73

5. Emerging Constraints to Sustained High Growth 75Growth Opportunities and Constraints 75

6. Summary and Conclusions 85

References 91Index 97About the Author 103


6

Acknowledgments

Much has been written about India’s growth experience.The monograph seeks to synthesize the existing knowledgeand underlying debate about India’s long-term growth. Itseeks to answer two key questions: what explains growth,and what needs to be done to further accelerate and sustainrapid growth? Comments from Marina Wes, DeepakMishra, Priya Basu, Ahmad Ahsan, Dipak Dasgupta, andAjay Chhibber of the World Bank are gratefully acknow-ledged. The main results of the research were presented attwo seminars, one in May 2006 at the Bangladesh Bank,Dhaka, and the other in October 2006 at the Indian Councilfor Research on International Economic Relations (ICRIER)in Delhi. I am deeply indebted to the participants for theirperceptive comments, which helped me sharpen the researchand analysis in several respects. In particular, I thank SyedMainul Ahsan and Salehuddin Ahmad of the BangladeshBank and Rajiv Kumar of ICRIER for sponsoring thoseseminars. Bala Bhaskar Naidu provided valuable researchassistance. Any errors are solely my responsibility.

FOREWORD

7

Foreword

Rapid growth since 1980 has transformed India from theworld’s 50th ranked economy in nominal US dollars to the12th largest in 2003. When income is measured in regardto purchasing power parity, India’s economy moves tofourth place, after the United States, Japan, and China.Along with income expansion, India’s increasingly outwardorientation is making it an important player in the globaleconomy. Already it is a major global service provider inthe area of information technology and related services.The growing optimism about India’s economy is leading toa surge in international investors’ interest, and at home thedebate has shifted from a concern with the ability to sustainan annual growth rate of 6 percent to the prospects forincreasing this to a sustained growth rate of 8 percent.

What factors have allowed India to achieve such rapid ratesof growth? How can India sustain the growth momentum?These are important questions and are the subject of thismonograph. Considerable research has been done to lookinto these issues, and there is a debate going on concerningthese issues. The monograph draws on this research andseeks to provide clarity to this debate.

To answer the first question India’s growth experience isbroken down into two distinct phases: the first phaserunning from 1950 to 1980 (phase I) and the second from1980 to 2004 and still ongoing (phase II). The analysis ofthis monograph shows that India’s movement to a highergrowth path happened in phase II, owing mainly to a majorshift in development strategy and associated policies, which


8

started in the 1980s. In phase I, the development strategywas inward looking and relied on a command and controltype of environment. In phase II, it became outward orientedand relied on market incentives. Key reforms includedcontinued prudent macroeconomic management, whichkept inflation and current account deficits under controlduring the period as a whole; exchange rate and tradeliberalization; financial sector liberalization; and domesticinvestment deregulation. Deregulation and outwardorientation along with broadly prudent macroeconomicmanagement yielded dramatic results as the economybecame more open and competitive, private investmentexpanded, and productivity surged.

The growth sustainability question concerns India’s abilityto increase the annual growth rate to 8 percent and sustainthat level. India has already achieved the 8 percent growthrate target during 2004–06. This monograph argues thatthis growth rate can be sustained because of a number offavorable factors: a growing labor force, a falling depend-ency ratio, rising savings and investment rates, expandingforeign direct investment with related technology transfer,and a dynamic private sector. To convert these favorablefactors into growth opportunities, the policy and institu-tional reforms must continue. In particular, reforms mustaddress the key constraints to growth: fiscal policy, infra-structure, labor market inflexibility, upgrading of labor forceskills, and public service delivery. India is slowly makingprogress in reducing fiscal deficits, but more needs to bedone to strengthen revenue mobilization and switch ex-penditure from wasteful subsidies in favor of infrastructureand human development spending. In regard to infrastruc-ture, an additional 5 to 6 percent of GDP needs to be invested

FOREWORD

9

to meet the infrastructure challenge through a combinationof carrying out fiscal reforms and mobilizing private re-sources. The lessons of experience with private participationin infrastructure suggest the importance of an adequatederegulation strategy, encouragement of competition, properpricing to preserve enterprise incentive, and proper regu-latory framework to protect public interest. Concerning jobcreation, an overhaul of labor laws for the formal sectorwith a view to ensuring a proper balance between employ-ment flexibility and the protection of workers’ rights is amajor reform priority. At the same time, the skill constrainthas to be relaxed by investing much more heavily in basiceducation than what was invested in the past, with a specialfocus on quality. Finally, although the private sector hasprospered from past reforms, the public sector has laggedbehind substantially owing to the inadequacy of relatedreforms. The problems include poor efficiency, poor services,weak accountability, and inadequate financial resources.Reforms entail a major overhaul of the underlying institu-tional arrangements for public services. This is yet anotherarea of reform challenge for India.


10

INDIA’S EMERGING GLOBAL SIGNIFICANCE

11

India’s Emerging Global

Significance: Can Growth

Accelerate Further?

India’s rapid growth since 1980 is transforming it intoa modern economic power. When income is measuredin nominal US dollars, India’s economy is found tohave risen from a low rank of 50 in 1979 to the world’s12th largest economy in 2003 (Figure 1.1). Whenincome is measured in relation to purchasing powerparity, India’s 2003 ranking climbs to the world’sfourth largest economy, behind only the United States,China, and Japan (Figure 1.2). Although India con-tinues to be classified as a low-income country in termsof per Capita nominal US dollars because of its hugepopulation, if present rates of growth continue, Indiashould reach low middle income status by the end ofthis decade.1 Importantly, in regard to purchasing powerparity, India on aggregate will likely become the thirdlargest economy after the United States and China.

In regard to the global impact on trade and investmentflows, the potential implications of this transformation,if sustained, are substantial. In regard to its share oftotal international trade and investment flows, Indiais still a small player because of the closed nature ofthe Indian economy until the 1980s. But as a result of

Chapter_1.pmd 1/31/2007, 2:19 PM11


12

Figure 1.1

World’s Largest Economies, 2003

USA Japan

Germany UK

France China

Italy Canada

Spain Mexico

Korea India

0 2,000 12,000 4,000 6,000 8,000 10,000 Gross National Income (GNI) (in current US$ billions)

GNI ($ bl)

Cou

ntry

Source: World Development Indicators (World Bank 2005a).

Figure 1.2

World’s Largest Economies in PPP Terms, 2003

USA China Japan India

Germany France

UK Italy

Canada Mexico

Spain Korea

0 2,000 4,000 6,000 8,000 10,000 12,000 Gross National Income (GNI) (in US$ billion in PPP terms)

GNI (PPP $ bl)

Cou

ntry


Chapter_1.pmd 1/31/2007, 2:19 PM12


13

the recent opening up of the economy, slowly but stead-ily India is gaining strength based on the rapid growthin the export of goods and services (Figure 1.3). Inparticular, services exports have surged since 2001(World Bank 2004a). India’s advantage in this line ofbusiness is drawing international attention, inducingmany global services based on computer technology tolocate to India. Private capital flows including foreigndirect investment were initially very limited but are nowshowing dynamism. Thus, foreign investment (directas well as portfolio) climbed from a meager US$100 mil-lion in 1990 to an average of about US$13 billionper year during 2003–04 (Government of India 2005).

India’s economic transformation is a recent develop-ment. Even during the 1970s, the debate in India cen-tered on what could be done to push the economy out

Figure 1.3

Growth in Export Values, 1990–2003

MexicoChinaIndia

KoreaSpain

CanadaUSAUK

ItalyGermany

FranceJapan

0 5 10 15 20Growth of Exports of Goods (percent per year)

Annual exports growth

Cou

ntry


Chapter_1.pmd 1/31/2007, 2:19 PM13


14

of the narrow bounds of the historical 3 percent annualgrowth rate. Critics humorously called this low averageannual growth rate the “Hindu growth rate.” Fewwould have predicted that this “sleeping giant,” vestedwith the world’s second highest population, would sud-denly start rolling and sustain an average growth rateof about 6 percent per annum over the past 25 years.Indeed, there are some signs that the growth rate couldaccelerate even further. For example, during 2002–05the annual average growth is estimated at 7.9 percent.Not surprisingly, there is growing optimism about thecountry. The debate has accordingly shifted to the fol-lowing question: Can the growth accelerate to 8 per-cent per year and be sustained at that level? A relatedquestion is what factors have allowed India to shiftfrom the 3 percent per year growth path to a 6 percentplus growth path?

These are important questions, and associated researchhas fueled a very lively debate. There are two aspectsof this debate. The first concerns the factors under-lying India’s long-term growth. One view believes thatIndia’s experience is a reflection of the “triumph” ofliberalization policies over state-led “command andcontrol” policies. A second view thinks that India’sexperience shows the importance of “heterodox” pol-icies in supporting growth. A third view regards India’sgrowth as an outcome of a business-friendly attitudinalshift in India’s policy making since 1980 rather thanthe result of liberalization policies.

The second aspect of the debate relates to the sustain-ability of growth. The growth pessimists are concernedthat India is facing a number of binding constraints

Chapter_1.pmd 1/31/2007, 2:19 PM14


15

that will make it difficult for India to sustain even the6 percent growth rate. So, sustaining 8 percent growthrate is highly unlikely. Related to this is the concernthat the easy reforms have taken place and the secondgeneration reforms have been more halting because ofpolitical constraints. Pessimists also worry about thelow employment elasticity of growth, the perceived im-balance of growth with heavy reliance on services rela-tive to manufacturing that threatens sustainability, andthe growing personal and interstate income inequal-ities that could fuel social unrest and disrupt the growthprocess. The optimists believe that although the social,political, and economic constraints are serious andneed to be addressed, the overall environment for eco-nomic expansion remains highly positive. Optimists seethe demographic pattern of an underused and growinglabor force as an opportunity rather than a constraint,which can be worked to India’s favor through policyreforms including education and training. The highand rising national savings rate, which is also benefitingfrom the demographic transition to a lower depend-ency ratio, along with the growing foreign investment,is yet another positive factor for growth. Similarly, thetechnology transfer and adoption options are manyand offer the prospects for continued good progresswith total factor productivity, another favorable factorfor sustained growth. Regarding the concern with thegrowth imbalance between manufacturing and services,the imbalance is seen as the result of policy outcomesrather than an inherent weakness of an unsustainablegrowth process. The risks to growth for manufacturingare similar to the risks for services. Finally, the strengthof the business community, a powerful and vocal

Chapter_1.pmd 1/31/2007, 2:19 PM15


16

middle class, and increasing global integration are un-leashing private sector dynamism not seen in the past.These forces are putting pressure on the political playersto address the emerging policy constraints to growth.

This monograph reviews the debate in the context ofIndia’s long-term growth experience, opportunities,and challenges. It examines the factors that helpedIndia achieve rapid economic growth during the past25 years. On the basis of this review, the main con-straints that are likely to cause worries for growth inthe future are analyzed and the policies that are neededto ease these constraints are highlighted.

The monograph is organized as follows. After theintroduction of the main theme and issues in Chapter 1,Chapter 2 examines the evolution and structure ofIndia’s long-term growth. Sectoral composition, theemployment issue, and the state-level context of thegrowth experience are considered in this chapter.Chapter 3 analyzes the determinants of growth in agrowth accounting framework. Chapter 4 reviews thepolicy framework that underpins the past growth ef-fort, and Chapter 5 provides a brief review of the emer-ging constraints and identifies the priorities for futurereform. Finally, Chapter 6 provides some conclud-ing remarks.

NOTE

1. For a definition of income categories, see World Bank 2005a.

Chapter_1.pmd 1/31/2007, 2:19 PM16

EVOLUTION OF INDIA’S LONG-TERM GROWTH

17

Evolution of India’s

Long-Term Growth

This chapter reviews India’s long-term growth in re-lation to total and per Capita GDP growth; the chan-ging composition of growth by the three broad sectorsof agriculture, industry, and services; the implicationsfor employment; and the growth experience by states.Sectoral composition provides useful informationabout the relative dynamism of these components andallows a better understanding of the employmentquestion. Similarly, because states have important flexi-bility in their policies, their growth experience alsoallows a better understanding of the determinantsof growth.

Trend in Total and per Capita GDP Growth:1950–2004

Figure 2.1 shows the pattern of India’s long-termgrowth. There are two distinct growth periods: a firstphase from 1950 to 1980 (phase I) and a second phasefrom 1980 to 2004 (phase II).1 The first phase is char-acterized by slow growth in both absolute andper Capita terms. In this period, India grew at an aver-age pace of only 3.6 percent per annum in absoluteterms and 1.2 percent in per Capita terms. In the second


18

phase, growth accelerated to 5.7 percent in absoluteterms and 3.8 percent in per Capita terms. Within thesetwo broad phases there are some interesting variations.During phase I, the decades of 1950–60 and 1960–70experienced almost identical growth rates (4 percentper year). But growth dipped substantially during1970–80 (3 percent per year), causing per Capita an-nual income to virtually stagnate at below 1 percent.Indeed, this decade saw the slowest pace of economicexpansion since independence. In phase II, the decadesof 1980–90 and 1990–2000 both experienced fairlyrapid growth (5.8 and 5.5 percent per year, respect-ively), but importantly, growth rate accelerated furtherduring 2000–2004 (6.2 percent per year). In addition,

Figure 2.1

India’s Long-Term Growth, 1950–2004

7

6

5

0

1

2

3

4

1950

–60

1960

–70

1970

–80

1980

–90

1990

–200

0

2000

–200

4

1950

–80

1980

–200

4

Period

GDP per capita GDP

Perc

ent

per

Ann

um

Source: Estimated from the data from the World Bank’s GlobalDatabase, August 2005.


19

if the effect of the estimated growth rate for 2005(8.2 percent) is added and the most recent years areexamined, the acceleration becomes quite prominent(Figure 2.2). Thus, the average annual rate of growthfor the period of 2002–05 is estimated at 7.9 percent.

Figure 2.2

India’s Recent Growth Path, 2001–05

10

9

8

7

6

5

4

3

2

1

0 2000 2001 2002 2003 2004 2005

Year

Rat

e of

Gro

wth

(%

)

GDP per capita GDP

Source: Estimated from the data from the World Bank’s GlobalDatabase, August 2005.

Fast growth rate since 1980 has placed India amongthe top nine rapidly growing economies of the world(Table 2.1). This is a list of countries that have grownby 5 percent or more per year during the past 23 years.Interestingly, India consolidated its gain during1990–2003, rising from its ranking as the eighth fastestgrowing economy during 1980–90 to the third fastestexpanding economy during 1990–2003. The growth


20

surge of the past 3 years (2002–05), if sustained duringthe next few years, will further strengthen India’s pos-ition. This could make India the world’s second fastestgrowing economy after China. However, despite therapid growth of the past 25 years in per Capita terms,India is still a very low income economy given the verylate start of its development. Thus, measured in nominalUS dollars, India’s per Capita GNP in 2005 was a mere2 percent of that of the United States. In purchasingpower parity terms, the share rises to 8 percent, still asmall proportion of the US per Capita income. Clearly,there is a huge amount of catching up still to be done.

Sectoral Composition of Growth

The broad sectoral composition of growth for differentdecades is shown in Table 2.2. Agriculture grew theslowest, at only 2.5 percent per year during 1960–2004.In contrast to that, both industry and services grew

Table 2.1

The World’s Fastest Growing Countries, 1980–2003

(percent per annum)

Country 1980–90 Rank 1990–2003 Rank 1980–2003 Rank

China 10.3 2 9.6 1 10.0 1Botswana 11.0 1 5.2 6 7.6 2Korea 9.0 3 5.5 5 7.3 3Singapore 6.7 6 6.3 2 6.5 4Oman 8.4 4 4.3 8 6.3 5India 5.7 8 5.9 3 5.8 6Thailand 7.6 5 3.7 9 5.6 7Mauritius 6.0 7 5.2 6 5.6 7Malaysia 5.3 9 5.9 3 5.6 7



21

more than twice as fast at about 5.7 percent per year.When compared by growth phases, all sectors showbetter growth performance in phase II than in phase I.Within phase I, the decade of 1970–80 was generallya difficult period for growth, especially for agriculture.Industrial growth also slowed in this period. Together,they pulled down GDP growth to only 3.1 percent peryear, the slowest pace of expansion in any decade since1950. More generally, except for 1980–90, agricul-ture grew at 3 percent or less, mainly at 2.5 percent orbelow. This growth is considerably weaker than thatin China or even Pakistan. The industrial sector main-tained a steady pace of growth, at 5.5 percent or moreper year, for most of the 54-year period except for thedeceleration during 1970–80. Acceleration in the ex-pansion of the services sector provided the mainimpetus to the GDP growth surge after 1980. Thus, theannual average services growth climbed from 4.5 per-cent during 1950–80 to 7 percent during 1980–2000.

Table 2.2

India’s Sectoral Composition of Growth, 1950–2004

(percent per year)

Agriculture Industry Services Total

1950–60 3.0 6.2 4.3 3.91960–70 2.3 5.5 4.8 3.71970–80 1.5 4.0 4.4 3.11980–90 3.4 7.1 6.7 5.61990–2000 2.5 5.6 7.6 5.62000–2004 2.3 6.1 8.2 6.31950–80 2.3 5.2 4.5 3.61980–2004 2.9 6.3 7.3 5.71950–2004 2.5 5.7 5.7 4.5

Source: World Bank Central Database, August 2005.


22

These differential sectoral growth rates have broughtabout a major structural transformation in the Indianeconomy. That is illustrated in Figure 2.3. The agri-cultural sector’s share of GDP shrank dramaticallythroughout the period, falling from 58 percent in 1950to only 21 percent in 2004. The industrial sector’s shareof GDP rose from 15 percent to 27 percent during thesame period. Most notably, the services sector’sshare surged from a low of 27 percent in 1950 to morethan 52 percent in 2004. Interestingly, industry’s shareof GDP has remained virtually unchanged at 27 per-cent since 1990, and services’ share moved up from41 percent to 52 percent, showing its dynamism. Thisstructural change of the economy has obvious impli-cations for employment and the income of the labor

Figure 2.3

Sectoral Share of GDP, 1950–2004

70

60

50

40

30

20

10

019601950 1970 1980 1990 2000 2004

Year

Perc

ent

(con

stan

t fa

ctor

cos

t)

Agriculture Industry Services

Source: World Bank Central Database, August 2005.


23

force. Unlike agriculture’s rapidly declining share ofGDP, employment’s share did not fall as much. As aresult, average productivity and wages grew muchslower in agriculture compared with in manufacturingand services (Virmani 2004a, 2004b; World Bank2006a). In tandem, people relying on labor incomefrom agriculture benefited less from overall GDP growththan workers employed in services and manufacturing.

Labor Force, Employment, and Real Wages

The somewhat unusual pattern of services-led growthhas fed some concerns about the sustainability ofgrowth as well as a worry about labor absorption(Kohli 2006). How unusual is India’s growth experi-ence in regard to sectoral composition? This issue hasbeen studied in some detail in a new research byKochar et al. (2006). The study concludes that althoughthe share of manufacturing in output and employ-ment in 1981 was at a normal level when comparedwith countries at a similar level of development andsize, this share lagged behind during 1980–2002. Incontrast the share of services in output and employmentwas below the norm in 1981, but although the outputshare of services surged ahead during 1980–2002, theemployment share lagged behind. The study also findsevidence that India’s services and manufacturing sec-tors tend to exhibit skill-intensive growth that is moretypical of advanced industrial countries as opposed toEast Asian countries.

Do these findings verify the pessimism expressed byKohli? Kochar et al. (2006) explain this pattern of growth


24

as reflecting partly the policy bias in India’s educationpolicies since the early days in favor of higher and sci-entific education as opposed to basic education andtraining and partly the effect of labor market policiesthat reduce employment flexibility and discriminateagainst labor-intensive enterprises. Clearly, therefore,this slower than expected growth of manufacturingis partly the result of a policy-induced constraint(inflexibility of the labor market) that has lowered theexpansion of labor-intensive manufacturing ratherthan an inherent weakness of the growth process inphase II. Similarly, as we shall see later in more detail,the services sector’s surge in phase II is the result ofreforms, including greater openness to global markets.The risks to its sustainability are linked to globaldownturn and the absence of further reforms, factorsthat will also hurt manufacturing growth. So, the sus-tainability of overall growth is not dependent on therelative balance between growth in services versusgrowth in manufacturing.

The issue of low employment creation is a substantialone. What is the evidence? Unfortunately comparablelong-term labor force and employment data are notavailable. We have more recent data pieced togetherfrom various sources in a recent employment studydone by the World Bank (2006a). On the supply side,labor force grew by 1.7 percent during 1983–2000(Table 2.3). The labor force is becoming better edu-cated, although the average level remains very lowwhen compared with the East Asian economies (ibid.).Also, the education gap between rural and urbanworkers on the one hand and between female and male


25

workers on the other is quite striking. On the demandside, employment actually grew faster than the supplyof labor, although the overall elasticity of employmentto GDP growth is low (only 0.3 percent). The fasteraggregate growth of employment relative to the laborsupply is also reflected in rising real wages (Table 2.4).

What then is the employment concern? The employ-ment and real wage concerns are actually driven bylow overall employment elasticity of growth, dif-ferential sectoral impact of employment, and the differ-ential rates of wage increases between sectors and bygender. First, although real wages grew economy-wide,the growth was slower than the expansion of per Capita

Table 2.3

Summary Labor Force and Employment Data,

1983/84–1999/2000

Growth Rate

(percent

1983/84 1999/2000 per year)

Labor force (million) 312.9 408.8 1.7Urban 63.1 100.0 2.9Rural 249.8 308.8 1.3

Employment 265.1 360.9 2.0Regular 39.0 57.4 2.4Casual 79.3 120.6 2.7Self-employed 146.8 182.9 1.4

Employment shareAgriculture 66.7 58.7Industry 12.0 12.1Services 21.3 29.2

Source: World Bank 2006a.


26

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27

income for low-skilled workers. This is a reflection ofthe overall low employment elasticity of GDP growth.Second, real wages grew much slower in agricultureas compared with non-agriculture. That is due to theslow growth in average labor productivity in agricul-ture, the very low levels of educational attainment ofagricultural workers, and the relatively slow growthin demand for labor in low-skill, labor-intensive non-agricultural activities. As a result, there is continuedstrong reliance on agriculture for employment. Thus,although the output share of agriculture has slumpedfrom 40 percent in 1980 to only 25 percent in 2004, theemployment share declined only marginally from66 percent in 1983/84 to 59 percent in 1999/2000(World Bank 2006a). The much slower growth of em-ployment in industry and services relative to their con-tribution to growth in output has constrained theoverall employment elasticity of output and the growthof real wages economy-wide. Third, there are substan-tial wage differentials between male and female work-ers. Finally, the wage differential between skilled andunskilled workers has widened (ibid.). These findingssuggest the need to address two key policy challengesmoving forward. First, there is a need to redress thedualistic pattern of skills by focusing on ways toupgrade the skill profile of the large bulk of theuneducated or low-skilled work force through ap-propriate reforms in education and training policies.Second, there is a need to remove the constraints tolabor market flexibility to allow a more labor-intensivepattern of growth.


28

Regional Pattern of Growth: State-Specific GDP

In India’s decentralized political environment in whichpolicies, resources, and institutions differ substantiallyby states, understanding the pattern of growth by statesis an important dimension of the growth diagnostics.Detailed reviews of state-level growth performanceare available in Ahluwalia (2002a), Bhattacharya andSakthivel (2004), and Krishna (2004). Unfortunately,reliable state-specific GDP data are available fromonly 1960 onward. The rates of growth by decade since1960 are shown in Table 2.5. Not surprisingly, growthhas varied significantly by states and by decades.During the low-growth phase (1960–80), most statesgrew slowly and close to the Indian national average.The exceptions were Haryana, Punjab, and Orissa. Thehigher growth in these three states was largely due tostrong growth in agriculture. During the second phaseof rapid national growth (1980–2003), a number ofstates took the lead in contributing to the growthacceleration: Gujarat, Karnataka, Maharashtra,Rajasthan, and West Bengal. The average growth inthese states equaled or exceeded the national average.A few states grew at about the national average:Haryana, Tamil Nadu, and Andhra Pradesh. But anumber of states lagged behind the national average,especially Bihar, Orissa, and Uttar Pradesh. The faster-growing states on average registered significantlyhigher rates of expansion in industrial and service sec-tors as compared with the lagging states.

Earlier we saw that agriculture on average grew muchless rapidly than services and manufacturing, especiallyduring the high growth phase. An interesting question


29

is, to what extent are the differences in state growthrates explained by the magnitude of the state’s relianceon the weakly expanding agriculture sector? The shareof agriculture in Gross State Domestic Product (GSDP)is shown in Figure 2.4. A number of interesting re-sults are seen. First, the share of agriculture fell for allstates, indicating that the non-agricultural activitiesexpanded relatively more rapidly in all states. Second,it is true that the poorest states of Bihar, Orissa, andUttar Pradesh remain relatively more reliant on agri-culture than the richer states of Maharashtra, Gujarat,Tamil Nadu, and Kerala. Third, yet it is also truethat some of the rapidly expanding states such as

Table 2.5

Regional Pattern of India’s Growth, 1960–2003

(percent per annum)

1960– 1970– 1980– 1990– 2000– 1960–1980–

State 70 80 90 2000 2003 80 2003

Andhra Pradesh 3.0 3.1 6.3 5.6 4.9 3.1 5.3Bihar 2.3 3.1 4.8 3.6 0.2 2.7 3.6Gujarat 4.6 3.5 5.3 6.2 11.0 4.1 6.5Haryana 5.9 4.5 6.4 4.9 6.3 5.2 5.6Karnataka 4.2 3.1 5.1 7.8 3.9 3.7 6.1Kerala 4.0 2.2 3.6 5.5 4.8 3.1 4.6Maharashtra 2.9 4.6 6.0 5.8 6.7 3.8 6.0Madhya Pradesh 2.1 3.0 5.1 3.8 6.7 2.6 4.8Orissa 9.8 2.9 2.8 4.4 6.7 6.4 4.0Punjab 4.6 4.8 5.2 4.7 2.8 4.7 4.7Rajasthan 4.7 1.0 7.4 4.7 5.2 2.9 5.9Tamil Nadu 2.8 1.7 5.6 6.4 1.4 2.3 5.4Uttar Pradesh 2.5 3.0 5.0 3.5 1.7 2.8 3.9West Bengal 2.2 3.1 4.3 6.7 7.1 2.7 5.7All India Average 3.7 3.1 5.6 5.6 6.0 3.4 5.7

Source: World Bank South Asia Regional Database, 2005.


30

West Bengal and Haryana and moderately growingstates such as Andhra Pradesh and Madhya Pradeshhave shares of agriculture that are larger than thenational average. Finally, Haryana and Punjab, bothrich states, have a very strong agricultural base. But,although Haryana has successfully diversified its econ-omy and sustained rapid growth, Punjab stagnatedduring the 1990s because of its weak ability to broadengrowth outside agriculture. These results suggest thata simple correlation between dependence on agricul-ture, the level of state per Capita income, and theoverall rate of growth will be misleading. Agricultureplays a substantial role in many states. But the dynamic

Figure 2.4

GSDP Share of Agriculture

0

10

20

30

40

50

60

Andhr

a Pra

desh

Bihar

Gujar

at

Har

yana

Karna

taka

Kerala

Mad

hya P

rade

sh

Mah

aras

htra

Oris

sa

Punj

ab

Rajasth

an

Tam

il N

adu

Uttar P

rade

sh

Wes

t Ben

gal

All In

dia A

vera

ge

Perc

ent

1980 2002

State

Source: World Bank South Asia Regional Database, 2005.


31

ones have diversified more rapidly and benefited froma more buoyant non-agriculture sector.

Given the initial differences in the states’ incomes, thedifferential growth rates, along with variable progressin tackling population growth, have brought aboutsubstantial differences in the per Capita income of thestates (Figure 2.5). The gap between the rich andpoor states widened particularly rapidly since the 1990s.The widening income gap between states has generateda substantial debate about liberalization policies andthe convergence of growth (Ahluwalia 2002a; Bajpaiand Sachs 1996; Purfield 2006). This divergence inper Capita state incomes has also led to largedifferences in the standard of living across states andprogress with poverty reduction. Not surprisingly, theincidence of poverty is highest in the poorest states ofBihar, Orissa, and Uttar Pradesh. The state-levelincome in-equalities have contributed to both a growthpessimism based on the fear of a social backlash and apopulist view that India’s rapid growth has not benefitedthe poor.

Growth, Poverty, and Human Development

Although the focus of this monograph is on growth, itis useful to take a summary look at the poverty andhuman development outcomes to dispel the populistview that higher growth benefits only a few and assuch the emphasis on growth is misplaced. At theglobal level, there is convincing empirical evidence thatgrowth and poverty reduction are positively correlated(Dollar and Kraay 2001). Table 2.6 summarizes the


32

Fig

ure

2.5

Ind

ian

Sta

tes’

Pe

r C

ap

ita

In

co

me

Tre

nd

s, 1

96

0–2

00

2

Sour

ce:

Wor

ld B

ank

Sout

h A

sia

Reg

iona

l D

atab

ase,

200

5.


33

Ta

ble

2.6

Ind

ia’s

De

ve

lop

me

nt

Ind

ica

tors

by

Gro

wth

Ph

ase

s

Se

lec

ted

In

dic

ato

rP

ha

se I

(1

95

0–

80

)P

ha

se I

I (1

98

0–

20

03

)

GD

P gr

owth

(%

p.a

.)3.

65.

7pe

r C

apit

a G

DP

grow

th (

% p

.a.)

1.2

3.8

Nat

iona

l po

vert

y in

cide

nce

(%)

45.3

(195

1–52

);43

.0(1

983–

84);

48.4

(197

7–78

)26

.0(1

999–

2000

)U

rban

pov

erty

(%

)35

.5(1

951–

52);

35.7

(198

3–84

);40

.5(1

977–

78)

23.5

(199

9–20

00)

Rur

al p

over

ty (

%)

47.4

(195

1–52

);45

.3(1

983–

84);

50.6

(197

7–78

) 2

7.0

(199

9–20

00)

Lif

e ex

pect

ancy

(ye

ars)

45(1

962)

; 54

(19

80)

54(1

980)

; 63

(20

03)

Infa

nt m

orta

lity

rate

(pe

r 1,

000)

146

(196

0);

115

(198

0)11

5(1

980)

; 60

(20

03)

Adu

lt l

iter

acy

rate

18.3

(195

1);

43.6

(19

81)

43.6

(198

1);

64.8

(20

01)

Prim

ary

enro

llmen

t ra

tio

78(1

970)

; 83

(19

80)

83(1

980)

; 10

7 (2

003)

Seco

ndar

y en

rollm

ent

rati

o24

(197

0);

30 (

1980

)30

(198

0);

52 (

2003

)

Sour

ces:

Gov

ernm

ent

of I

ndia

200

5; W

orld

Ban

k 20

00,

2005

a.


34

average poverty and selected human developmentoutcomes for India during the two growth phases. Theresults are quite striking, although not surprising. Pro-gress with poverty reduction was very slow in bothurban and rural areas during phase I. The pace of pov-erty reduction picked up substantially in phase II,supported by the acceleration in growth. Progress withhuman development was similarly better in phase II.So, it is reassuring that higher growth did allow Indiato make faster progress in improving the well-beingof its citizens. State-level analysis shows not only thatpoverty was reduced in all states but that there is alsoa similar positive correlation between growth and pov-erty (Deaton and Kozel 2005; World Bank 1997). Theincidence of poverty tends to be lowest in the high perCapita income states and highest in the slow-growing,low-income states. So, a part of the development chal-lenge is to find ways to accelerate growth in the laggingregions rather than abandon the growth accelerationeffort. Nevertheless, there is also evidence that incomeinequality increased (Deaton and Kozel 2005), andhuman development indicators remain weak by inter-national standards, including the quality of health andeducational outcomes. These facts suggest that alongwith more rapid growth India needs to pay strongerattention to improving equity.2 The education and train-ing and labor market reforms mentioned earlier areimportant elements of a policy reform package to im-prove equity in India.

NOTES

1. For a more nuanced and detailed review of India ’s long-term growthexperience and phases of growth, see Virmani (2004a).

2. For a good review of growth and equity issues, see World Bank 2005b.

DETERMINANTS OF GROWTH: GROWTH ACCOUNTING

35

Determinants of Growth:

Growth Accounting

Following the seminal work on growth by Solow (1956),the growth accounting analysis shows that growth perunit of labor depends on capital accumulation and factorproductivity. Increase in one or both can raise the rateof growth. Capital accumulation in turn depends onthe rate of investment. In a market economy, invest-ment depends on profitability. The profitability ofinvestment depends in part on the price of capital, whichis affected by the national savings rate and externalcapital flows. External capital flows also have an effecton the ability to acquire new technology and therebyaffect total factor productivity. How have these ele-ments played out in India?

Savings and Investment

Figure 3.1 shows the trend in savings and investment.Over the longer term, India’s savings and investmentrates have increased substantially. Both savings andinvestment rates have grown steadily throughout allthe decades, rising from the low levels of 10 to 12 per-cent, respectively, during the 1950s to the 23 percentrange in the 1990s. The national savings rate surgedfurther to 27 percent during 2000–2004, buoyed by


36

inflow of remittances. Overall, the average investmentrate in phase II (23 percent of GDP) was much higherthan that in phase I (15 percent of GDP). It is cleartherefore that the higher growth rate since the 1980shas indeed been supported by a more rapid pace ofinvestment.

Total Factor Productivity

The emphasis on total factor productivity (TFP) resultsfrom the theory that the sustainability of growth over

Figure 3.1

Trend in Savings and Investment, 1950–2004

30

25

20

15

10

5

0 1950 1960 1970 1980 1990 2000

Decade Average

Savi

ngs

and

Inve

stm

ent

Rat

es (

%)

Savings Investment

Source: World Bank Central Database, August 2005. Datafor 2000 refers to the average for 2000–04.


37

the longer term will depend on the ability to makecontinuous TFP improvements. Without improvementsin TFP, diminishing returns to factor accumulationwill drive down the growth rate over the longer term.Several studies have analyzed developments in India’sTFP. The more recent ones include Rodrick andSubramanian 2004, Virmani 2004b, Acharya et al. 2003,and Bosworth and Collins 2003. The results of thesestudies are summarized in Table 3.1. Despite differ-ences in assumptions and methodology, there is a re-markable degree of consistency in the studies’ results.The stylized facts appear to be as follows: First, TFPhas played an important role in pushing long-termgrowth in India. Second, there has been a signifi-cant increase in TFP and its contribution to growthin phase II. Indeed, international comparison ofTFP contribution to growth done by Bosworth andCollins (2003) suggests that India scored very lowduring 1960–80 (at only 10 percent) compared withother countries. However, the contribution of TFPsurged to 57 percent during 1980–99, which is in thetop performer category.

Growth Accounting: A Summing Up

The evidence summarized above suggests that the ac-celeration in India’s rate of growth in phase II overphase I occurred as a result of both a sharp increase incapital accumulation and a strong improvement in pro-ductivity. The surge in the national savings rateobserved during 2000–2004 and evidence of increasingforeign capital inflows suggest that financing does notappear to be a constraint to further increases in the


38

Ta

ble

3.1

Ind

ia’s

To

tal

Fa

cto

r P

rod

uc

tiv

ity

Est

ima

tes

(pe

rce

nta

ge

an

nu

al

ave

rag

e g

row

th r

ate

s)

A.

Ach

arya

et

al.

1950

/51–

1967

/68–

1981

/82–

1991

/92–

1966

/67

1980

/81

1990

/91

1999

/200

0G

DP

3.8

3.4

5.3

6.5

TFP

1.4

0.7

2.0

2.6

Prop

orti

on o

f G

DP

grow

th e

xpla

ined

by

TFP

(%

)38

2138

40B

. V

irm

ani

1950

–80

1980

–200

3N

et d

omes

tic

prod

uct

(ND

P) p

er w

orke

r1.

32.

4T

FP0.

72.

4Pr

opor

tion

of

per

wor

ker

ND

P gr

owth

exp

lain

ed b

y54

69T

FP (

%)

C.

Bos

wor

th a

nd C

ollin

s19

60–7

019

70–8

019

80–9

019

90–9

9G

DP

per

wor

ker

1.9

0.7

3.9

3.3

TFP

gro

wth

0.7

–0.5

2.5

1.6

Prop

orti

on o

f pe

r w

orke

r G

DP

grow

th e

xpla

ined

by

40ne

gati

ve64

48T

FP (

%)

D.

Rod

rick

and

Sub

ram

ania

n19

60–7

019

70–8

019

80–9

019

90–9

9G

DP

per

wor

ker

1.8

0.9

3.7

3.3

TFP

1.2

0.5

2.9

2.4

Prop

orti

on o

f pe

r w

orke

r G

DP

grow

th e

xpla

ined

by

6756

7873

TFP

(%

)

Sour

ces:

Ach

arya

et

al.

2003

, B

osw

orth

and

Col

lins

2003

, R

odri

ck a

nd S

ubra

man

ian

2004

, V

irm

ani

2004

b.


39

investment rate. The better prospects for foreign invest-ment also suggest stronger opportunities for accumu-lation of better technology, which is a positive factorfor total factor productivity and growth.

FOREWORD

1

POLICY FRAMEWORK FOR SUPPORTING GROWTH

41

Policy Framework for

Supporting Growth

From an accounting perspective, there is no disagree-ment that the per worker growth rate depends on theinvestment effort and the pace of productivity growth.The debate has centered on what determines the in-vestment rate and productivity growth. This has trans-lated into a debate about the role of specific policiesin supporting growth. A summary of this debate canbe found in Ahmed (2006). In regard to India, thecontroversy is about the role of deregulation policiesversus “attitudinal changes.” The implications of lib-eralization policies for supporting growth in India havebeen studied extensively (Acharya 2006; Ahluwalia2002b; Krueger and Chinoy 2002; Panagriya 2005;Virmani 2005; World Bank 2000, 2003). These studieshave provided evidence that the growth momentumsince the 1980s has much to do with pro-marketreforms. The reforms started in the 1980s but ac-celerated in the 1990s. This received wisdom has beenchallenged recently in a new study that concludes that“growth was triggered by an attitudinal shift on thepart of the national government towards a pro-business(as opposed to pro-liberalization) approach” (Rodrickand Suramanian 2004, from the abstract).


42

A careful review of the debate appears to suggest thatthis has less to do with the substance and more withthe choice of time period and the interpretation of as-sociated reforms. In regard to the time period, the dis-tinction between the two sub-periods of phase II,1980–90 and 1991–2004, is overdrawn. The facts areclear: the upward shift in the growth path occurredafter 1980, not 1991. But to argue that growth during1980–90 occurred as a result of attitudinal changesrather than pro-market reforms is misleading. Thegovernment’s shift from an inward-looking, command-and-control economy to an outward-oriented, incentive-based, private sector-led economy is indeed at the heartof the reforms during phase II. Calling them “pro-business” rather than “pro-market” does not changethe substance that these reforms were directed atimproving the incentives for the private sector. AsPanagriya (2005), Virmani (2005), and Joshi andLittle (1998) have shown, some significant pro-marketreforms took place during 1980–90. Many others tookplace after the crisis of 1991. Reforms in both periodswere geared to improving incentives for the privatesector. During 1980–90, the government signaled itschange in development strategy through reforms thatwere easy wins. A large share of the growth impactcame from better use of existing capacities reflected inTFP improvement. From 1991 to 2004, more funda-mental market-oriented reforms took place. A largershare of the growth response in this period came fromcapital accumulation, although TFP contribution re-mained substantial. Importantly, most researchersagree that without the reforms of the 1990s, the growthspurt of the 1980s could not have been sustained.


43

Against the backdrop of the above, this monographshows that the low investment effort and low prod-uctivity improvements of phase I were the result ofweak incentives and low efficiency resulting from ahighly controlled and inward-looking economy. Theexchange rate was overvalued and inflexible, trade andcapital flows were highly restrictive, the financial sec-tor was heavily controlled under public ownership,and investment regulations were overwhelming. Inphase II, the exchange rate was made flexible, exchangecontrols were removed, financial sector was reformed,trade restrictions were progressively removed, and in-vestment was deregulated. So, essentially, in the firstphase, the Indian economy was inward looking andmanaged by state-led command-and-control inter-ventions. In the second phase, the economy was moreoutward oriented and driven by the private sectorthrough market-based incentives. These are two dif-ferent development strategies and policy regimes withmarkedly different growth outcomes. Below, we lookat underlying policies in some greater detail.

Macroeconomic Stability

It is now well accepted that macroeconomic stabilityis an essential condition for sustained long-term growth.It is, however, also recognized that macroeconomicstability is a necessary but not sufficient condition forgrowth. For example, if macroeconomic stability ismaintained through tight controls over monetary,fiscal, exchange, and trade policies, the likely outcomewill be macroeconomic stability with low growth.Consequently, the policy challenge is to preserve


44

macroeconomic stability while supporting high growth.Related to this, there is a debate about the role of indi-vidual policies in reconciling macroeconomic stabilitywith growth. In India, this debate has centered on theappropriate role of fiscal policy.

Two key indicators of macroeconomic stability arethe internal balance, measured by the rate of inflation,and the external balance, measured by current accountdeficits.1 The trend in inflation is shown in Figure 4.1.Relative to the rest of the world and other non-oil-exporting developing countries, on average India hasexperienced significantly lower inflation over the longerterm. Inflation was especially low in the 1950s, started

Figure 4.1

Inflation in India, 1950–2004

40

1950 1960 1970 1980 1990 2000

35

30

25

20

Infl

atio

n R

ate

(% p

.a.)

15

10

5

0

India World Developing Countries

Sources: IMF 2000, 2001, 2002, 2003, 2004, 2005.

Year


45

climbing up during the 1960s to the 1990s, and fellsharply during 2000–2004. This pattern is broadly con-sistent with the international experience. On the whole,inflation was higher in phase II than in phase I. Yet,even during phase II the average annual inflation ratewas below 8 percent and significantly lower than theworld inflation rate. India’s inflation rate compared withthat of other developing countries looks rather tame,even for phase II. The overall conclusion is that onbalance India’s long-term development is characterizedby a fairly stable internal macroeconomic environment.This result is valid for both growth phases, althoughthe inflation rate was higher in phase II.

In regard to external balance, the trend in current ac-count deficits and other related indicators are shownin Table 4.1. As in the case of internal balance, Indiaon average has maintained good control over its ex-ternal balance over the longer term. Low current ac-count deficits have allowed India to maintain lowexternal debt-to-GDP ratios. However, there are majordifferences in India’s external sector results duringphase I and phase II.

In phase I, India was essentially a closed economy witha very low trade-to-GDP ratio. So, the low currentaccount deficits, debt, and debt service payments inthis period are more a reflection of tight trade controlsrather than deft external management. India facedfrequent episodes of short-term external paymentsproblems because of low export earnings and reserveseven with substantial import controls (Joshi andLittle 1998). In phase II, a substantial opening up ofthe trade regime took place. During the initial period


46

of the opening up, the external balance weakened,leading to the external crisis of 1991 (Acharya 2006;Ahluwalia 2002b; Krueger and Chinoy 2002;Srinivasan 2002). Following this crisis, there was asharp improvement in the external balance contri-buting to rapid declines in external debt-gross nationalincome (GNI) and debt service-export ratios, a currentaccount surplus, and a huge buildup of reserves. So,notwithstanding the crisis of 1991, India’s externalbalance was markedly stronger in phase II.

The overall result is that on average India has main-tained a stable macroeconomic environment. But thishas been associated with two sharply different growthphases. We will argue below that policies that allowedIndia to maintain macroeconomic stability were verydifferent in these two phases. In phase I, policies formacroeconomic stability were not conducive to growth.

Table 4.1

India’s External Balance, 1950–2004 (percent)

Indicator 1950 1960 1970 1980 1990 2004

Current a/c deficit/ 1.0 2.0 0.3 1.5 1.7 –0.3GDP (periodaverage)

External debt/GNI 1.1 4.8 15.0 11.0 27.0 19.0External debt/exports 16 100 396 137 325 105Debt service/exports 2.0 5.0 7.0 9.0 32.0 19.0Foreign reserves 1.8 0.4 0.8 6.9 1.5 126

(US$ bl)Reserves (% of 1.64 0.17 0.38 0.46 0.06 1.34

annual imports)

Sources: International Finance Statistics, IMF; World BankCentral Database, September 2005.


47

Whereas in phase II, the policy combination allowedIndia to accelerate growth while maintaining soundmacroeconomic management. India’s experience veri-fies the well-known analytical conclusion that macro-economic stability is necessary, but not sufficient, forrapid growth.

POLICIES FOR INTERNAL BALANCE

Although a coordinated approach to macroeconomicpolicies is necessary to reconcile growth targets withmacroeconomic stability, it is customary in an openeconomy to attach primacy to monetary policy for pricestability, to exchange rate for stability of the balanceof payments, and to fiscal policy for growth. Overthe longer term, price stability depends primarily onmonetary stability (Cagan 1974; Friedman 1973). Ina developing economy, the level of monetization willincrease over time. Allowing for that, the rate of expan-sion of the money supply should normally be alignedwith the growth of real economic activity (GDP) andthe target inflation rate. The relationship between in-flation, real growth, and monetary expansion for Indiais shown in Table 4.2. As expected, there is an almostone-to-one long-term relationship between the rate ofgrowth of the money supply and inflation, less thegrowth of GDP. The upward rise in inflation in phase IIis explained by the increase in the money supply perunit of GDP relative to phase II. The increase in moneysupply is partly a reflection of increased monetizationof the economy and partly a function of the long-terminflation target. Whether India targets inflation at 7 to8 percent or 5 to 6 percent over the longer term is adebatable policy issue, which in a globally integrated


48

environment also needs to be seen in the context of theworld inflation outcome. On the whole, the ability tocontain India’s inflation rate at substantially below theworld rate and the rate prevailing in non-oil-exporting,developing countries during both phases is a testimonyto the sound conduct of monetary policy. This is par-ticularly encouraging because India faced manyexternal shocks and the associated adverse effects ofimported inflation during phase II when it opened upthe economy as opposed to the closed economy en-vironment of phase I.

POLICIES FOR EXTERNAL BALANCE

The trend in real exchange rate is shown in Figure 4.2.During most years in phase I, India’s real exchangerate was highly overvalued relative to the current realrate (Gulati and Pursell 1995; Srinivasan 1998). Be-tween 1950 and 1985, India essentially followed a

Table 4.2

Money, GDP, and Prices, 1950–2004

Decade Growth Rate Growth Rate of Inflation

Average of Money (M1) Real GDP Rate

1950–60 4.0 3.9 2.21960–70 9.5 3.7 6.11970–80 11.7 3.1 7.81980–90 15.3 5.6 8.91990–2000 15.1 5.6 9.02000–2004 14.8 6.3 3.81950–80 8.4 3.6 5.41980–2004 15.1 5.7 7.91950–2004 11.4 4.5 6.6

Sources: International Financial Statistics, IMF; World BankCentral Database, September 2005.


49

fixed exchange rate policy. The nominal rate was fixedat Rs 4.78 per US$1 from 1950 to 1965. It was de-valued in two steps, by 33 percent in 1966 and byanother 18 percent in 1967, when it became clear thatthe overvalued exchange rate was not sustainable. Thenew rate of Rs 7.5 per US$1 remained fixed until themid-1970s, after which the rate was slowly adjustedupward until 1980. In phase II, the real exchange ratewas allowed to depreciate sharply to realign India froma closed to an open economy. Thus, since 1981, thenominal exchange rate was made much more flexiblewithin the environment of a managed float. Indiaformally moved to a market-based exchange rate in 1992.The real exchange rate depreciated until 2000 in linewith market sentiments. The appreciation since then isan indication of the strength of India’s external balance,reflecting the sharp build-up of foreign exchange re-serves noted in Table 4.1.

Figure 4.2

Trend in Real Exchange Rate, 1950–2004

50

45

40

35

30

25

20

15

10

5

01950 1960 20001970 1980 1985 1990 1995 2004

Time Period

Rea

l Exc

hang

e R

ate

(Rs/

$)

Sources: IMF 2000, 2001, 2002, 2003, 2004, 2005.


50

Figure 4.3

Trend in Export Performance, 1950–2004

20

18

16

14

12

0

2

4

6

8

10

1950 1960 20041970 1980 1990 2000Year

X/GDP

Exp

orts

of

Goo

ds &

Non

-fac

tor

Serv

ices

as

% o

f G

DP

Sources: IMF 2000, 2001, 2002, 2003, 2004, 2005.

The exchange rate flexibility since the 1980s, alongwith trade opening up and deregulation (see below),had a substantial positive effect on exports. India’s ex-ports performance virtually stagnated during 1950–70.Exports as a share of GDP fell from 7.8 percent in 1950to below 4 percent in 1970 (Figure 4.3). Exports re-covered in the 1970s reaching 7 percent of GDP by 1980.In phase II, exports grew slowly during the 1980s, butexpanded rapidly during 1990–2004. As a result, theshare of exports climbed from about 8 percent of GDPin 1990 to 19 percent in 2004.

CONDUCT OF FISCAL POLICY—STABILIZATION VERSUS GROWTH

The conduct of fiscal policy has been a subject ofintense debate in India, especially in the second phase


51

of growth. In the early years after independence, India’sfiscal stance was conservative. The average fiscal def-icit during 1950–70 was 3 to 4 percent of GDP (seeFigure 4.4).2 Fiscal expansion started in the 1970s andsurged in the 1980s. Since then, despite some efforts tocurb the deficits, they have remained large. Thus, formore than 35 years India has maintained fairly largefiscal deficits, building up a huge domestic public debtand large interest payment obligations. For example,debt-to-GDP ratio has now reached 90 percent, andinterest payment obligations have climbed from lessthan 1 percent of GDP during the 1950s to 6.5 percentin 2005. This is larger than the total public investmentin 2005, illustrating the burden of past deficits. Yet,the macroeconomy has been broadly stable while

Figure 4.4

India’s Fiscal Deficits, 1950–2005

10

9

8

7

6

5

4

3

2

1

01960–701950–60 1970–80 1980–90 1990–2000 2000–2005

Period

Def

icit

(% o

f GD

P)

Fiscal Deficit Primary Deficit

Sources: Economic Survey, Ministry of Finance (Government ofIndia 2005) and World Bank Regional Database,September 2005.


52

growth has accelerated. At the heart of the controversyis indeed whether India’s expansionary fiscal policyhas been a source of long-term sustained growth.

The analytical basis for using fiscal deficits to pushgrowth is provided by the Keynesian view that in aneconomy with unemployed resources, demand cre-ation through fiscal stimulus could provide a boost togrowth. Coordinated monetary policy and exchangerate management would ensure price and balance ofpayments stability. This is a fairly persuasive and neatframework. How relevant is this to India’s case?

A simple-minded approach to India’s experience wouldseem to validate that view. Growth and fiscal deficitswere relatively low during phase I. Growth did pick upsubstantially in phase II along with large and rising fiscaldeficits. Except for the short-term crisis in 1990/91,macroeconomic stability was also preserved. But thisis too simplistic a view and does not stand up to carefulscrutiny of the reality in India.

As per theory, depending on how the deficits are fi-nanced, large fiscal deficits would tend to become un-sustainable because (i) if deficits are financed bydomestic borrowing, then they would tend to crowdout private investment by raising domestic interestrates; (ii) if deficits are financed by money creation,then this will feed on inflation; and (iii) if deficits arefinanced through external borrowings, they will con-tribute to balance of payments crisis. In the case ofIndia, much of the deficits were financed through non-bank domestic sources, which partly explains why thesedeficits did not contribute to high rates of inflation or


53

to balance of payments pressures over the longer term.Yet, during 1980–90, large fiscal deficits did createdemand pressure on the balance of payments, leadingto the external payments crisis of 1990/91. The crisiswas addressed quickly through a series of far-reachingreforms including more flexible management of theexchange rate and substantial trade liberalization(Acharya 2006; Ahluwalia 2002b; Krueger andChinnoy 2002; Srinivasan 2002).

What were the effects of fiscal deficits on interest rateand private investment? This issue was researchedthoroughly in a recent paper (Pinto and Zahir 2003).The study concludes that there is indeed evidencethat large fiscal deficits in India have put pressure onreal interest rates and crowded out private invest-ment. Other studies also reached similar conclusions(Reynolds 2001; World Bank 2000). In the past,government control over interest rates through dom-inant public sector banking made it easier to divertresources to the public sector at low cost. With thegradual liberalization of the financial markets, as hastaken place recently, the crowding out effects couldbecome more severe than that in the past.

Did these deficits contribute to growth? In the shortterm, with excess capacity, a generalized demand stimuluscould lead to growth acceleration. Over the longerterm, the growth impact will depend on whether or notfiscal deficits are used to finance investments that arecomplementary to private investment (e.g., infrastruc-ture) and the degree of crowding out. In the case of India,there is some evidence that fiscal stimulus did boostgrowth in the 1980s. Liberalization policies created


54

incentives to utilize existing capacities better. Fiscalstimulus created the demand for this (Srinivasan 2002).During the longer term, the implication of large fiscaldeficits for growth has varied over time. In the initialyears, the fiscal deficits did contribute to financing agrowing public investment (Figure 4.5), but as interestcost grew and tax effort faltered, the public investmentrate begun to fall. So, over the longer term, these deficitshave become a constraint to growth (Acharya 2006;Ahluwalia 2002b; Ferro et al. 2004; Srinivasan 2002;World Bank 2003). This is partly because the growingpublic debt has created a huge debt servicing burden,as noted earlier. Also, a significant part of the fiscaldeficit is financing current spending, including subsidies.

Figure 4.5

Public Investment and Fiscal Deficit, 1950–2005

12

10

8

6

4

2

01950–60 1960–70 2000–20051970–80 1980–90 1990–2000

Decade

Perc

enta

ge o

f G

DP

Public Invt. Fiscal Def.

Source: Economic Survey 2005–06, Ministry of Finance (Govern-ment of India 2005).


55

The shrinking fiscal space has limited the capacity tofinance investments in infrastructure and humancapital at both the federal government and the stategovernment level. There is evidence of fiscal stress inmany states, thereby constraining developmentprospects (World Bank 2005b).

SUMMARY OF EVIDENCE—IMPLICATIONS OF MACROECONOMICPOLICIES FOR GROWTH

India’s experience brings out several interesting pointsabout the relationship between macroeconomic pol-icies and growth. First, for more than 50 years, Indiaon average has maintained a fairly stable macro-economic environment. In regard to internal balance,the average long-term inflation rate has been about6.6 percent per annum, below the world average of8.8 percent and substantially below the average forlow-income economies (12.5 percent). Concerning ex-ternal balance, India kept its average current accountdeficit at about 1.3 percent of GNI per year, therebyrestricting its external debt to only 19 percent of GNIas of 2004. Exports have surged from less than 8 per-cent of GDP in 1950 to 19 percent in 2004, reserveshave increased from less than 17 percent of annual im-ports in the 1960s to 134 percent of 2004 imports, andthe external debt service burden in 2004 was below20 percent of exports. Second, the policies that allowedmacroeconomic stability during phase I were funda-mentally different from policies that supported macro-economic stability during phase II. In the first phase,macroeconomic stability was maintained through mon-etary tightening, control over the exchange rate, tradebarriers, and exchange controls. The policies were not


56

aimed at supporting private investment. Not surpris-ingly, they adversely affected private investment andgrowth. They, along with other regulatory restrictions,were an important reason for relatively low private in-vestment and low factor productivity during this period.In the second phase, monetary policy was somewhatless tight than that in the first phase but remained with-in prudent limits, thereby keeping the inflation ratesignificantly below average rates for the world andfor developing countries. Most important, the exchangerate was made flexible sequentially, until this becamemarket determined. Exchange controls were progres-sively eliminated, and trade policies were liberalized.These policies spurred private investment and exports,which in turn were an important factor for rapidgrowth. Third, the conduct of fiscal policy yielded mixedresults. In an effort to break out of the low-growthsyndrome of phase I, India adopted an expansionaryfiscal policy stance in phase II. This policy had someinitial success, and public investment increased, contri-buting to higher growth. However, the momentumcould not be sustained. Much of the deficit was fi-nanced domestically. As a result, the domestic debtand interest burden surged, reducing the availabilityof resources for public spending in infrastructure. Alsothere is some evidence of the crowding out of privateinvestment. So, even though the long-term adverse ef-fects of large fiscal deficits on macroeconomic stabilitywere offset by monetary, exchange rate, and tradepolicies, the efficacy of expansionary fiscal policy forsustained growth has proven limited owing to the grow-ing fiscal debt service burden and the crowding out ofprivate investment.


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Policies for Improving Incentivesfor Private Investment

The incentives for domestic and foreign private invest-ment are affected by the overall investment climate(World Bank 2004c). Several factors influence theattractiveness of the investment climate: property rightsand security of doing business, access to markets, andthe cost of doing business.

PROPERTY RIGHTS AND SECURITY OF DOING BUSINESS

These have partly to do with law and order, the func-tioning of the judiciary, and the like, and partly withthe government’s strategy and attitude toward theprivate sector. In phase I, India’s development strategyemphasized public investment and production for mostof the organized economy. The attitude toward privateenterprise could at best be described as benign neglect.Not surprisingly, the bulk of formal sector output, em-ployment, and investment occurred in the public sector(Joshi and Little 1998; Virmani 2005). Private enter-prise dominated informal sector comprising agricul-ture, much of which was of the traditional type withrelatively small holdings, medium and small manu-facturing, and informal services. There was a big shiftin development strategy in the second phase, as govern-ment policy moved away from the emphasis on publicproduction and investment to private production andinvestment (Virmani 2005). This is the change in “at-titude” described by Rodrick and Subramanian (2004)as “probusiness,” which paid off rich dividends. How-ever, improvements in the legal framework to supporta modern private sector in areas such as the ease of


58

conflict resolution, bankruptcy laws, and the like havenot moved as rapidly (World Bank 2004b).

ACCESS TO MARKETS

In phase I, India’s imports were heavily restricted withan associated loss of efficiency and competitiveness(Acharya 2006; Bhagwati 1998; Joshi and Little 1998;Pursell 1992; World Bank 2004d). Import restrictionswere used to support the import substitution indus-trialization drive as well as to manage the balance ofpayments. Export subsidies and occasional devaluationwere used to push exports. Some significant initial ef-forts were made to reduce quantitative barriers after1975 and continued through the first decade of phase II(Joshi and Little 1998; Panagriya 2005; Virmani 2005).But the main trade liberalization effort was madeafter the 1991 external crisis (Acharya 2006; WorldBank 2004d).

The evolution of India’s trade policy is illustrated inTable 4.3. During phase I, non-trade barriers (NTBs)were the main instrument of trade policy. Import con-trols with varying degrees of severity were used to regu-late the balance of payments as well as to support theimport substituting industrialization strategy. Duringphase II, the policy of gradual relaxation of importcontrols initiated in 1975 was continued. By this policychange, more import items were allowed under theOpen General Licensing Scheme. As a result, importsgrew substantially during 1975–90. Nevertheless, evenas late as 1991, some 95 percent of import items weresubjected to some kind of restrictions. At the same time,the tariff rates were increased primarily to raise revenues.Thus, as of 1990, the average tariff rate was 128 percent,


59

with the maximum rate at 300 percent. Since 1991,India’s trade regime has undergone a rapid transfor-mation (Table 4.3). Import controls were dismantledthrough a series of steps, and by 2001 these restric-tions were officially eliminated. In practice, some re-strictions on both imports and exports have remained,although they fall legally within the limits of the frame-work of India’s commitments to the General Agree-ment on Tariffs and Trade (GATT) and the World TradeOrganization (World Bank 2004d). The peak and aver-age tariff rates were brought down substantially, thelatter falling from 300 percent in 1990 to 30 percentin 2004, and the former declining from 128 percent in1990 to 22 percent in 2004. Clearly, India’s traderegime today is vastly more liberal than it was in 1990.

Table 4.3

Evolution of India’s Trade Policy

Trade Policy Indicator 1990 2000 2004

Imports subject to non-tariff 95 28 0 to smallbarriers (NTBs) (%)

Average tariff (%) 128 40 22Import-weighted tariff (%) 87 30 n.a.Peak tariff (%) 300 40 30

Sources: World Bank 2000, 2004d.

Along with the flexibility of the exchange rate, the ef-fect of trade liberalization on trade growth was remark-able. Exports, which had fallen from 8 percent of GDPin 1950 to only 4 percent in 1970, showed some re-covery, increasing to 6 percent of GDP in 1980. Sincethen, responding to a more flexible exchange rate andreduction in trade barriers, exports grew sharply to19 percent of GDP in 2004. Similarly, the import share


60

initially fell from about 8 percent of GDP in 1950 to4 percent in 1970, illustrating the severity of importcontrols. Imports recovered to 10 percent of GDP by1980 and accelerated to 22 percent in 2004. As a result,the overall share of trade grew from only 14 percentof GDP in 1980 to 41 percent in 2004 (Figure 4.6).Although this is still lower than China’s trade share,the change is quite remarkable. Trade liberalization hasplayed an important role in supporting the expansionof private investment and growth during the secondgrowth phase. For example, Chand and Sen (2002) andTopalova (2004) find empirical evidence that tradeliberalization has raised total factor productivity (TFP)in Indian manufacturing. Similarly, Virmani (2005)

Figure 4.6

India Trade Openness Indicator, 1950–2004

45

40

35

30

25

20

15

10

5

01950 1960 1970 1980 1990 2000 2004

Year

Trade/GDP

Tra

de/G

DP

(%)

Sources: IMF 2000, 2001, 2002, 2003, 2004, 2005.


61

finds that lower trade protection and depreciation ofthe real exchange rate had significant positive effectson the growth of TFP in manufacturing.

Although there was limited progress with trade reformsduring 1980–90, it is misleading to conclude that tradereforms are not needed to support rapid growth. Theexternal crisis of 1991 suggests that without trade lib-eralization and the flexibility of the exchange rate,India’s ability to sustain the rapid growth of 1980–90would not have been possible. So, from this longer-term perspective, trade liberalization is an importantdeterminant of rapid long-term growth in India.

COST OF DOING BUSINESS

Several factors affect the cost of doing business. Re-search done at the World Bank suggests that the keyfactors include regulatory barriers to entry and exit,availability of financial services at competitive prices,availability and cost of infrastructure, and flexibilityof labor laws.

Regulatory Barriers

The emergence of myriad controls for economic man-agement during the first phase has been well docu-mented. Good descriptions of the evolution of thesecontrols is available in Bhagwati and Desai (1970),Joshi and Little (1998), and Virmani (2005). Thecontrols regulated investment, production, and distri-bution activities in all three broad economic sectors—agriculture, industry, and services. Thus, there werecontrols over the amount of investment, the type ofactivities, location, employment, ownership, and pric-ing. Such was the reach of these controls that a special


62

term was coined to ridicule the system: the reign ofIndia’s licensing raj. The adverse effects of these con-trols on private investment and economic performancehave been tremendous (Joshi and Little 1998; Kruegerand Chinoy 2002; Virmani 2005). The deregulationdrive started in the 1980s but gained momentum afterthe 1991 crisis (Panagriya 2005; Virmani 2005). Inaddition to the substantial trade deregulation describedearlier, many of the regulatory barriers to privateinvestment were removed. These include the elimin-ation of investment licensing; sharp cutback in activ-ities subject to public sector monopoly; substantialreduction of regulatory restrictions on foreign invest-ment; opening up of domestic and foreign investmentsin services such as airline, telecoms, and power (areaspreviously under public monopoly); and privatization.

Financial Sector Reforms

During the first phase, India moved rapidly to a state-owned and heavily regulated financial sector. Thus in1955, India’s largest private bank, the Imperial Bank ofIndia, was nationalized and renamed the State Bankof India. In 1956 the life insurance business was nation-alized. An array of specialized financial entities wascreated to provide long-term finance and to guidefinancial resources to activities through state inter-ventions. Interest rates were controlled by the state.In this environment there was no capital market andall enterprises had to rely for financing on state-ownedbanks, insurance companies, and specialized financialinstitutions. The financial depth (measured by M2/GDP) was initially stagnant for well over two decades(1950–70) at about 23 percent of GDP. Eventually,the spread of public banking including in rural areas,


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low inflation, and high domestic savings, all supportedthe growth of banking resources despite the controls.Thus, the financial depth grew from 23 percent of GDPin 1970 to 37 percent in 1980. However, credit wasmisallocated to the so-called priority sectors withoutregard to the financial rate of return. Similarly themassive drive to spread public banking to rural areaswithout regard to profitability lowered the bankingsectors’ profitability. So both the efficiency and the fi-nancial health of the system suffered (Basu 2005;Joshi and Little 1998; World Bank 2000). Importantly,the financing needs of a modernized private sectorwere not met because of the lack of an appropriatecapital market.

Phase II saw the implementation of major financial sec-tor reforms in a series of steps. Financial sector reformswere initiated in 1985. The initial emphasis was toderegulate interest rates and to deepen the financialmarket by introducing additional money market instru-ments (Basu 2005). Financial reforms were consider-ably strengthened after the crisis of 1991 (Basu 2005;World Bank 2000). Based on the recommendations ofthe Narasimham Committee Report, a sweeping setof market-friendly reforms were implemented. Thesereforms were strengthened in 1998. The 1998 reformsfurther deregulated interest rates, reduced reserve re-quirements to raise bank profitability, strengthenedprudential norms and disclosure rules, tightened bank-ing supervision, further developed monetary and for-eign exchange instruments, enhanced the flexibility ofbanks to manage their own portfolio by reducing thescope for directed credits, increased banking sector com-petition through a greater role for foreign and domestic


64

private banks, and initiated the development of amodern capital market. The impact of the reforms hasbeen far-reaching. The ratio of M2/GDP has sharplyincreased from 37 percent in 1980 to 66 percent in2004 (Figure 4.7). Banking sector profitability has in-creased, and the health of the financial sector hasimproved (Basu 2005; World Bank 2000). Importantly,a buoyant capital market has emerged, which has con-siderably increased the financing options for business.

Impact of Deregulation Reforms

Along with the flexibility of the exchange rate, theimpact of trade, investment, and financial deregulationon private investment has been remarkable. The pri-vate investment rate as a share of GDP surged from

Figure 4.7

Trend in Financial Depth, 1950–2004

70

60

50

40

30

20

10

01950 1960 20041970 1980 1990 2000

Year

M2/GDP

M2/

GD

P (%

)

Source: International Financial Statistics, IMF.


65

10.8 percent of GDP in 1970–80 to 18.2 percent in2000–2005 (Figure 4.8). Much of the response until thelate 1990s came from the domestic private sector. For-eign direct investment was sluggish, partly because thederegulation drive was a bit conservative initially.Thus, in 1990/91 net foreign investment was onlyUS$103 million, and it grew to US$2.3 billion in1998/99.3 This pattern, however, is now changing inresponse to stronger efforts to deregulate and improvethe business environment for foreign private investment.Thus, foreign investment increased to US$13.7 billion(2 percent of GDP) in 2003/04.

Figure 4.8

Private Investment Trend, 1950–2005

14

12

10

8

6

4

2

0

16

18

20

1950–60 1960–70 1970–80 1980–90 1990– 2000

2000– 2005

Period Average

Priv I/GDP

Perc

ent

of G

DP

Source: Economic Survey 2005–06, Ministry of Finance (Govern-ment of India 2005).


66

Availability of Infrastructure

It is now well recognized that the availability of ef-ficient and affordable infrastructure services is a neces-sary condition for growth. This is reinforced by thebusiness responses to the Investment Climate Assess-ment in India and elsewhere (World Bank 2004b, 2004c).Several studies analyzing India’s growth prospects iden-tify infrastructure as among the most important con-straints to future rapid growth (Ahluwalia 1998, 2002b;Krueger and Chinoy 2002; McKinsey 2001; World Bank2004b, 2006a). In this era of global competition, goodinfrastructure can make the difference between a com-petitive firm and a non-competitive one. For example,a recent study of horticulture export prospects for Indiashows dramatically how poor infrastructure constrainsthe expansion of this potentially high-growth exportactivity (World Bank 2005d).

From the early years after independence and well upto 1990, India relied almost entirely on public invest-ment as the main instrument for infrastructure supply(World Bank 2000). Between 1960 and 1990, on aver-age, India spent some 4.5 percent of GDP on infrastruc-ture. The average investment rate grew from about4 percent in the 1960s, to 4.5 percent in the 1970s andfurther to 5 percent in the 1980s (Joshi and Little 1998).Although these investment rates were reasonableduring the initial years and helped build relevant cap-acities, there are serious concerns about the efficiencyof service and asset maintenance owing to poor man-agement and inappropriate pricing policies (Ahluwalia1998; World Bank 2000). Infrastructure managementis also constrained by the division of responsibilities be-tween the federal government and the state governments.


67

Thus, electricity and water are primarily state subjects.Performance by states has been uneven, depending onthe ability to manage complicated political issues re-lated primarily to the pricing of electricity and water.

As GDP growth accelerated during the second phase,the demand for infrastructure grew. At the same time,public investment contracted owing to fiscal problems(Ahluwalia 1998; World Bank 2000). Given the magni-tude of the required additional resources (conserva-tively estimated at 5 to 6 percent of GDP per year) formaintenance and new investment, it became clear thatcontinued reliance on the public sector alone would notwork. So, some serious rethinking about engaging theprivate sector for infrastructure supply started in the1990s along with efforts to improve the efficiency ofthe public supply. A major policy of deregulation wasinitiated in the latter half of the 1990s, and there hasbeen some remarkable progress in areas such as airlineservices, telecommunications, and ports (Ahluwalia 1998;World Bank 2003, 2006a). Reforms have entailedremoval of entry barriers, greater competition, properpricing of services, and establishment of regulatoryauthorities. Progress in other areas, such as power, landtransport, and water, was less encouraging.

The poor performance of the power sector is amongthe most notable failures of public policy in India. Thesource of the difficulty is almost similar in all SouthAsian countries: provision of electricity through weakand inefficient public entities. The problem is com-pounded by government control over prices and poorsector governance. As a result, the entities are financiallyconstrained, have serious generation and transmission


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losses (mostly owing to theft), and have low installedcapacities owing to inadequate investment. Indeed,over the years, the capacity of the electricity utilities tofinance investment from their own resources hasweakened, leading to substantial reliance on the gov-ernment. Fiscal problems of state governments in Indiaare partly a reflection of high subsidies to electricityentities. The growing fiscal deficit in turn has con-strained the ability to fund the required investment inthe electricity sector as well as in other infrastructure.Efforts to reform these entities and encourage the pri-vate supply of electricity have met with limited success(Ahluwalia 1998; Sundar and Deb 2001). This is mainlybecause reforms have not addressed the fundamentalconstraint: electricity must be viewed as a commercialproduct; it should be produced and priced primarilyon the basis of demand and supply, although appro-priately modified through regulatory policies to protectthe public interest. The principles are well known, butpolitical constraints have prevented fundamental re-forms. Indeed, state elections have often been won andlost on the basis of whether or not governments agreeto provide free electricity for farmers.

In transport, the problems relate to roads and highwaysand railways. In regard to roads and highways, a keyconstraint is funding, for both new investments andmaintenance, owing to fiscal problems. In the past, thechief emphasis of government investment in the roadsubsector was on district and rural roads to promoteconnectivity. The focus on highways was limited. Morerecently, the government has started investing heavilyin major interstate corridors with support from inter-national sources. Some limited progress has also been


69

made in promoting the concept of toll roads. Yet, thefunding needs are enormous. Maintenance of the roadnetwork is inadequate, thereby reducing the supply ofservices from the road network. In railways, the issuesconcern poor management, low prices, overstaffing,and traffic safety (Mohan 1996). The problems andreform options are well known (ibid.). Implementationis constrained by politics; the railway union has a hugevoice in national politics, and no government has riskedits political capital to take on this powerful union.

In water, the issues are similar. The responsibility forproviding drinking water and irrigation lies with stategovernments. Poor pricing and management havelimited both new investment and water availabilityfrom existing facilities. In regard to irrigation, publicinvestment has financed major irrigation schemes. Pri-vate investment has concentrated on power-driven deeptube wells. Heavily subsidized electricity to farmershas led to inefficient water use and overexploitationof ground water. Public irrigation facilities are char-acterized by poor operations and maintenance (O&M)owing to financial constraints. Poor maintenance hascontributed to substantial water losses, thereby reduc-ing the supply to users. Water charges are very lowand do not cover even the efficient O&M needs. Fiscalconstraints at the state level have also reduced new in-vestment in public irrigation.

Overall, the state of infrastructure shows a mixed pic-ture. Reforms during the 1990s have opened up infra-structure to private investors. Very good progress hasbeen made in telecommunications and airline services.


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Some encouraging progress has also been made inports. But reforms in power, roads, railways, and waterare inadequate. Along with a very tight fiscal situation,which has constrained public investment and spendingon O&M, the overall availability of infrastructure ser-vices in these areas is inadequate relative to need. Thisis a major constraint to future rapid growth and re-quires substantially more attention.

Labor Regulation

As a key production input, labor market flexibility isan important determinant of firm profitability in anymodern economy. In India, except for minimum wages,all other labor laws in effect apply to only the formalsector. This sector comprises the industrial establishmentwith more than 10 workers and all government services.In 1981, the size of the formal sector was estimated at23 million (9 percent of the total labor force). Of this,some 68 percent of formal sector employment wasprovided by the public sector (Joshi and Little 1998).Much of this was in government services, includingpublic utilities. Public sector manufacturing accountedfor only 25 percent of formal employment. Over time,as liberalization proceeded and the private sector grew,the relative employment share of the public sector fell.Importantly, the share of public sector employment informal manufacturing reduced further. So, essentially,labor laws are of substantial interest to the formal manu-facturing and to new private investment in the servicessector, especially infrastructure.

There are some 47 federal laws and 157 state regu-lations relating to labor relations (World Bank 2006b).The state governments are responsible for implementing


71

these laws. So, actual implementation varies by states.Labor laws fall into two main categories: those thattend to affect wage decisions and those that affecthiring and firing, closure, and employment conditions.Interventions in wage setting include minimum wages,wage board awards, dearness allowance, and bonuspayments. Market wages in the formal sector tend tobe higher than minimum wages. Therefore, it is not amajor issue for employers. The wage board awards arenot binding unless the state government itself adoptsthe awards. Dearness allowance and bonus paymentrequirements can cause some discomfort. Overall,though, wage interventions tend to be more of an irri-tant than a major constraint to private enterprise(Joshi and Little 1998; World Bank 2006b). But lawsrelating to employment, closure, and employment con-ditions are stringent and are an important constraintto private investment.

Investment climate assessments show that the issue ofmanaging labor lay-off is the biggest challenge. Theemployment termination decision was initially guidedby the Industrial Disputes Act of 1947. The lay-offprocess under the act was fairly mild: the law appliedonly to permanent workers in establishments with 50or more workers and required 15 days of compensationfor each year of service. Over the years, through var-ious amendments the law was made more and moredemanding. In 1976, employment termination wasmade illegal for all enterprises with employment inexcess of 300 workers, even if an enterprise was seekingto close down, without previous permission of the gov-ernment. This restriction was extended to firms with100 plus workers in 1982.


72

The other clause of the Industrial Disputes Act that hascreated major concern is the dispute resolution mech-anism. Experience shows that the specified disputeresolution mechanism creates incentives for adjudi-cation rather than reconciliation and has led to an over-load of the system. For example, some 533,000 labordisputes were pending in 2005, with more than 28,000cases for more than 10 years (World Bank 2006b).

Another labor regulation concerns the employmentof temporary workers. As a means of avoiding theemployment inflexibility created by the IndustrialDisputes Act, entrepreneurs have tended to establishsmaller firms (fewer than 100 workers) and hire tem-porary workers. Indeed, contract labor has assumedan increasingly important role in recent years. To regu-late this type of employment, the government enactedthe Contract Labor Regulation and Abolition Act;however, there is confusion about the act’s relevanceand application.

The costs of these labor regulations are significant inrelation to lost jobs. Research shows that manufac-turing value added, employment, and the number offactories are all adversely affected in states with morerestrictive labor laws. Estimates suggest that India mayhave failed to create about 2.8 million formal manu-facturing jobs owing to the two clauses of the IndustrialDisputes Act mentioned earlier (World Bank 2006b).Although the disputes resolution and the retrench-ment barriers are both problematic for job creation,they affect different sectors in different ways. Althoughdispute-related regulations cost more jobs in capital-intensive industries, retrenchment-related regulationsaffect labor-intensive industries more adversely.


73

The need for labor regulations to protect workers’interests is understandable, and the regulations mustbe honored by employers. The question is one of bal-ance. The present plethora of laws and regulations areunnecessary and hurt employment. These must giveway to simpler regulatory laws that protect labor rightswhile also providing the flexibility of employment deci-sions necessary in a changing global environment. Thisis a major priority for future reform.

Reforms at the State Level

In India’s decentralized political environment, stateregulations and constraints can also affect growth. Wesaw in Chapter 2 that the growth at the state level hasvaried considerably between the two growth phases.A number of studies have looked into the issue of re-forms and state-level performance (Ahluwalia 2002a;Favaro and Lahiri 2004; Howes et al. 2003; Purfield2006; World Bank 2006b). Results confirm the hypoth-esis that faster-growing states on balance have carriedout more reforms in deregulation and better fiscalmanagement than have slower-growing states. Al-though initial conditions pertaining to advantagesrelated to the location of existing industry, infrastruc-ture, and human development did help, states withmore reform-minded governments were able to attractmore investment and push the growth rate at a fasterpace than in the lagging states. Thus, faster-growingstates on average have a better investment climate, lead-ing to higher labor productivity and better returns toinvestment (World Bank 2004b).


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The differential growth performance and the growinggap between rich and poor states suggest the need tomanage this problem more actively than in the past.A review of the constraints in the lagging regions showsthat apart from weaker policy performance in theseregions, there are important constraints that requirespecial attention from policymakers in the center(World Bank 2006b). Although commodity marketsappear to be getting better integrated across states andwage differentials are declining, there is still an im-portant unfinished agenda in regard to a more inte-grated national economy across states. The gap in infra-structure and human development between the rich andpoor states is another major factor that requires moreattention and responses from the federal government.This has important implications for the allocation offiscal transfers. The main challenge though is a politicalone: how to induce better economic and political gov-ernance in the lagging regions to allow implementationof better policies.

NOTES

1. The rationale for defining macroeconomic stability in this way isexplained in Ahmed (2006).

2. For the 1950–70 period, the fiscal deficit is estimated as the differencebetween public savings and investment.

3. Foreign investment data were obtained from Economic Survey,2005–06, Ministry of Finance (Government of India 2005).

EMERGING CONSTRAINTS TO SUSTAINED HIGH GROWTH

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Emerging Constraints to

Sustained High Growth

The debate in the 1990s was about whether India’srapid growth of 6 percent per year could be sustained.The debate in 2006 has shifted to whether growth canbe pushed up to a higher level of 8 percent per year andsustained at that higher pace. The shifting nature ofthe debate reflects the growing optimism about India’sremarkable economic transformation and associatedgood results in relation to more rapid growth. As wesaw in Chapter 2, the average rate of growth is on anincreasing trend and average annual growth was above7 percent in 2004–05. It reached the 8 percent growthrate in 2005. Although that is encouraging, the asso-ciated question of what India needs to do to sustainsuch rapid growth is an important one.

Growth Opportunities and Constraints

India’s growth experience and associated structuralchanges have unleashed a number of growth oppor-tunities as well as growth constraints. Opportunitiesinclude a dynamic private sector willing and able torespond dramatically to incentives; an expandingglobal market, especially in services, that gives Indiatremendous potential to raise its market share based


76

on its demonstrated comparative advantage in this areaof global enterprise; an expanding labor force thatcould be harnessed with adequate investment in edu-cation and training; and a high domestic savings ratethat could provide the base for attracting foreign in-vestment and technology. India’s ability to convertthese opportunities to its benefit will very much dependon its ability to address and ease the growth constraints.

Chapter 3 noted that India’s growth surge in phase IIwas fueled by increases in the rate of investment andproductivity. Future growth will depend on how thesefactors play out.

SAVINGS AND INVESTMENT RATES

India’s savings and investment rates showed an in-creasing trend during 2000–2003. The average rates havegrown from 23 percent and 22 percent of GDP, respect-ively, during 1990–2000 to 25 percent and 23 percent,respectively, during 2000–2005. The savings and invest-ment rates have increased further during 2004–05 to27 percent and 25 percent, respectively. These ratesare encouraging, but are significantly lower than thosefound in rapidly growing East Asian economies(Figure 5.1). It is important to note that there is nomechanical relationship between growth and capitalaccumulation, and one cannot specify a necessary rateof investment to sustain a specific rate of growth be-cause capital intensity of production can vary andmuch also depends on technical progress and the effi-ciency with which capital is used (productivity growth).India’s past experience shows that very effectively; theaverage capital intensity of production was relativelylower than that in East Asian economies, and TFP


77

growth played a much more significant role thancapital accumulation in increasing GDP per worker.Indeed, high rates of capital accumulation withoutimprovements in TFP could simply hide a great dealof inefficiency. Nevertheless, it is most likely that sus-tained growth rate in the 8 to 10 percent range peryear will require significantly higher investment ratesthan the present 25 percent rate. That is becauseIndia’s infrastructural needs are substantial, as are itsneeds for skilled labor. Both will require higher in-vestment. Average investment rates in the range of30 percent or above are most likely required. There-fore, one important constraint to more rapid growththat will need to be addressed is how to raise the rateof investment to the 30 percent plus range.

Figure 5.1

Average Savings and Investment Rates, 2000–2003

45

40

35

30

25

20

15

10

5

0E. Asia & PacificIndia China

Perc

ent

of G

DP

GNS/GDP GDI/GDP

Source: World Bank Global Database, August 2005.


78

PRODUCTIVITY GROWTH

Chapter 3 showed that TFP increased substantially inphase II. Indeed, the fact that TFP growth explainsmore than 60 percent of India’s GDP growth perworker during phase II is a remarkable result. Therapid productivity and investment growth of phase IIwere underpinned by a major change in developmentstrategy and associated policies. Prudent monetarymanagement, flexibility of the exchange rate, financialsector deregulation, trade liberalization, and invest-ment deregulation have all served India well. Thesereforms must continue to their next stages. Yet, becauseof a number of constraints, it is not obvious that furtherincreases in investment rate or productivity improve-ments will automatically happen simply by continuingthe present policy framework. These constraints in-clude fiscal policy, infrastructure, labor market inflexi-bility, low investment in education, and public servicedelivery. There is a consensus that these constraintsadversely affect the investment rate, productivity,and employment.

FISCAL POLICY CONSTRAINT

Fiscal policy constrains growth by limiting the abilityof the federal and state governments to invest ad-equately in human development and infrastructure.Chapter 4 explained that the option of creating fiscalspace through a larger deficit is not feasible becauseof its likely adverse effects on private investment. Whatis the way out? There are two major policy impli-cations. First, the tax effort can be enhanced throughappropriate changes in the tax structure and adminis-tration. The possible options have been well studied


79

and reviewed (Acharya 2006; Favaro and Lahiri 2004;Government of India 2001a, 2001b, 2002a, 2002b).At 16 percent of GDP, India’s tax effort is low byinternational standards, and a 2 to 3 percent increasein the tax collections as a percent of GDP appears tobe a reasonable goal. Second, and perhaps even moreimportant, the quality of public spending can besubstantially improved. That requires both carry-ing out expenditure switching actions, away fromextensive subsidies to more funding for human devel-opment and infrastructure, and increasing the effi-ciency of spending. A good review of related issues isavailable in Favaro and Lahiri (2004). The high levelof subsidies on a range of goods and services is costingIndia some 3 to 4 percent of GDP. There is a consensusthat these subsidies are not well targeted and the op-portunity cost is high. The subsidies administeredthrough price controls (e.g., electricity prices) also haveserious adverse implications for service providers. Yet,the federal and state governments are locked in as aresult of political pressure. In a tight fiscal environ-ment, there is a need for a renewed debate about andeffort to revisit the subsidy issue and make changesas required.

INFRASTRUCTURE CONSTRAINT

A survey of investors confirms the serious nature of thisconstraint. Some observers also argue that the growthof the manufacturing sector is less dynamic than thatof the services sector partly because of this constraint.The resolution of this situation requires a substantialincrease in investment and the efficiency of infrastruc-ture service delivery. Securing the estimated additional


80

investment in the range of 5 to 6 percent of GDPnecessary for augmenting the supply of infrastructureand improving its maintenance will not be easy. Fiscalreforms noted earlier will be necessary to create fiscalspace for public investment in infrastructure. But giventhe magnitude of the financing needs, other competingpriorities, and experience with the slow pace of imple-mentation of past fiscal reforms, it is essential to relymore on private financing of infrastructure. India’srising national savings rate and growing foreign capitalinflows suggest that such financing should be possibleprovided the enabling environment to attract privatesector in infrastructure supply is sharply improved. Theexperience so far is mixed, with a great deal of successin the areas of telecommunications and airlines, en-couraging results in ports, but discouraging outcomein electricity supply. The lessons from these mixedexperiences can be drawn on to develop a cohesive in-frastructure development strategy. Lessons include theimportance of an adequate deregulation strategy, en-couragement of competition, proper pricing to preserveenterprise incentive, and proper regulatory frameworkto enable private investment while protecting the publicinterest. Moving ahead with a comprehensive infrastruc-ture development strategy is perhaps the most pressingreform required to ensure a higher growth path.

LABOR MARKET CONSTRAINT

In addition to infrastructure, the inflexibility of thelabor market is a major constraint to the dynamismof the large-scale manufacturing sector. With a rela-tively abundant labor force, India can be expected tohave a comparative advantage in labor-intensive


81

manufacturing enterprises. For this advantage to berealized, among other things the labor market must beflexible. Yet, the restriction on labor flexibility imposedby the Industrial Disputes Act constrains the growthof such enterprises. Ensuring the fair treatment of laborand protecting the workers’ rights are essential. Butthis need not be inconsistent with employment flexi-bility. An overhaul of labor laws with a view to ensuringa proper balance between employment flexibility andprotecting workers’ rights is another key reform priority.

SKILLS CONSTRAINT

It was noted in Chapter 2 that India has a dualisticpattern of skills development. On the one hand, thelarge bulk of the labor force either is illiterate or haslow levels of education and, on the other, there is avery limited but highly skilled labor force that competeseffectively internationally. Although the average levelof education of the labor force has shown some im-provement, the level remains very low especially incomparison with East Asian economies. This dualisticpattern of skill formation emerged partly from gen-erally low levels of public spending on education andan education policy that has been biased since inde-pendence against basic education and in favor of higherand specialized education. The bias has also been ac-centuated by an industrial policy during phase I thatemphasized investment in capital-intensive heavyindustries and the inflexibility of the labor market re-sulting from the unhelpful labor laws noted earlier.Although the investment in highly skilled labor haspaid off for India in phase II by allowing it to benefitfrom an expanding global market for services, this has


82

constrained the needed transformation of its large poolof unskilled workers into more productive and skilledlabor. The lack of labor market reforms has tended tokeep the bias against expansion of labor-intensive manu-facturing even during phase II. So, along with the re-form of labor laws, India needs to invest much moreheavily and conscientiously in basic education than ithas in the past. Special efforts are needed to improveeducation quality. Reform of education and trainingis essential to take advantage of the favorable demo-graphic pattern reflected in a growing labor force andto convert the large pool of low-productivity labor inagriculture into a semi-skilled/skilled labor force forthe manufacturing and formal services sectors.

PUBLIC SERVICE DELIVERY CONSTRAINT

The deregulation strategy has yielded very good resultsin a booming private sector and higher investment andincomes, which is creating enormous demand pressureon the public sector for various services. Yet, the publicsector response has lagged behind substantially. Thatslow response is emerging as a major constraint to growthand human development. The imbalance reflects theinadequate capacity and low efficiency of the publicsector to address the needs of a rapidly transformingeconomy. There are two dimensions of this challenge.The first relates to the ability to adapt to the changingrole of the public sector from the command-and-controltype of environment of phase I to the incentive-basedenvironment of phase II. The second relates to directservice delivery.

The experience so far with the adaptation of the pub-lic sector to a more deregulated economy is mixed.


83

The ability of the federal government to develop andimplement economywide reforms has shown good pro-gress, as demonstrated by the successful implemen-tation of wide-ranging reforms of the past two and ahalf decades. The role of the Planning Commission,the main institution responsible for developing andimplementing the command-and-control economy, hasslowly but surely changed to that of indicative planningand incentives. But progress at the federal agency leveland at the state level is mixed. Similarly, progress inestablishing regulatory agencies is also mixed.

In regard to direct service delivery, the record in health,education, water, roads, irrigation, and electricity isweak. A number of recent studies (World Bank 2006b,2006c) have done a comprehensive analysis of the keyissues relating to public service delivery and the wayforward. The associated reform challenges are enor-mous. The issues include low efficiency, poor services,poor accountability, and weak finances. Resolution ofthese issues requires an overhaul of the entire publicservice delivery system. Reforms are under way in sev-eral federal- and state-level service agencies with someencouraging results (World Bank 2005c). The lessonsof these experiences can be helpful in designing broaderpublic sector reforms. The associated institutional re-forms involve a number of common principles: estab-lishing clear responsibility for service delivery based onmeasurable performance indicators in regard to out-puts and outcomes, providing operational and financialautonomy to the service agency, ensuring account-ability for the delivery of agreed services, and enforcingsanctions for nonperformance (World Bank 2006b).

FOREWORD

1

SUMMARY AND CONCLUSIONS

85

Summary and Conclusions

Rapid growth since 1980 has transformed India fromthe world’s 50th ranked economy in nominal US dol-lars to the 12th largest in 2003. When income is mea-sured in purchasing power parity, India’s economymoves to fourth place, after the United States, Japan,and China. Along with income expansion, India’sincreasingly outward orientation is making it an im-portant player in the global economy. Already it is amajor global service provider in the area of informationtechnology and related services. The growing optimismabout India’s economy is leading to a surge in inter-national investors’ interest, and at home the debate hasshifted from a concern with ability to sustain an annualgrowth rate of 6 percent to the prospects for increasingthis to a sustained growth rate of 8 percent.

Although there are differences in economic policiesbetween and within decades, from a broad devel-opment strategy perspective, India’s growth experiencecan conveniently be broken down into two phases:the first phase running from 1950 to 1980 (phase I) andthe second phase from 1980 to 2004 and ongoing(phase II). The analysis in this monograph shows thatIndia’s transformation to a higher growth path occurredin phase II, owing mainly to a major shift in developmentstrategy and associated policies starting in the 1980s.


86

In phase I, the development strategy was inwardlooking and relied on a command-and-control type ofenvironment. In phase II, the development strategybecame outward oriented and relied on market incen-tives. Key reforms included continued prudent macro-economic management, which kept inflation and currentaccount deficits under control over the period as awhole; exchange rate and trade liberalization; financialsector liberalization; and domestic investment deregu-lation. Deregulation and outward orientation alongwith broadly prudent macroeconomic managementyielded dramatic results as the economy became moreopen and competitive, private investment expanded,and productivity surged. Thus, the trade-to-GDP ratiomoved up from 23 percent in 1980 to 41 percent in2004, private investment increased from 7 percent ofGDP in 1980 to 17 percent in 2004, and the averagerate of growth increased from 4 percent per year dur-ing 1950–80 to 6 percent during 1980–2004. The con-tribution of total factor productivity to GDP per workerincreased from an average of 10 percent per year inphase I to more than 60 percent in phase II.

The encouraging outcomes of phase II reforms haveboosted India’s economic prospects. The policy chal-lenge now is whether the growth rate can be expandedto 8 percent and maintained at that level. This morerapid growth rate is necessary to make faster progressin enhancing the living standards of India’s citizens.Notwithstanding the past rapid growth, India’s perCapita income is very much behind that of the Organ-ization for Economic Co-operation and Developmentcountries, and there is a great deal of catching up to do.


87

The first priority of course is to ensure that ongoingreforms continue to their next stages. Yet, because ofa number of constraints, it is not obvious that furtherincreases in the investment rate or continued product-ivity improvements will occur simply by continuingwith the present policy framework. There is a con-sensus that these constraints adversely affect the invest-ment rate and productivity and must be addressed toachieve higher growth. The constraints concern fiscalpolicy, infrastructure, labor market inflexibility, up-grading of labor force skills, and public service delivery.

Fiscal policy constrains growth by limiting the abilityof the federal and state governments to invest ad-equately in human development and infrastructure.The option of creating fiscal space through a largerdeficit is not feasible because of its likely adverse effectson private investment. What is the way out? There aretwo major policy implications. First, the tax effort canbe enhanced through appropriate changes in the taxstructure and administration. Second, and perhapseven more important, the quality of public spendingcan be substantially improved. That improvement re-quires both carrying out expenditure switching actions,away from extensive subsidies to more funding forhuman development and infrastructure, and increasingthe efficiency of spending.

Resolution of the infrastructure challenge requires asubstantial increase in investment and the efficiencyof service delivery. Mobilizing the additional invest-ment in the range of 5 to 6 percent of GDP, which isnecessary for augmenting the supply of infrastruc-ture and improving its maintenance, will not be easy.


88

Fiscal reforms noted earlier will be required to createfiscal space for public investment in infrastructure. But,given the magnitude of the financing needs, othercompeting priorities, and experience with the slow paceof implementing fiscal reforms in the past, it is essentialto draw more on private financing of infrastructure.There are some positive experiences with privatefinancing of infrastructure in areas such as telecom-munications, airlines, and port services. The key lessonsinclude the importance of an adequate deregulationstrategy, encouragement of competition, proper pricingto preserve enterprise incentive, and proper regulatoryframework to protect public interest. Moving aheadwith a comprehensive infrastructure development strat-egy is perhaps the most pressing reform needed forhigher growth.

With a relatively large labor force, India can be expectedto have a comparative advantage in labor-intensivemanufacturing enterprises. For this advantage to berealized, among other things the labor market mustbe flexible. Yet, the restriction on labor flexibility im-posed by the Industrial Disputes Act constrains thegrowth of such enterprises. Ensuring fair treatment oflabor and protecting workers’ rights are crucial. Butthis need not be inconsistent with employment flexi-bility. An overhaul of labor laws for the formal sectorwith a view to ensuring a proper balance between em-ployment flexibility and the protection of workers’rights is a major reform priority.

India has a dualistic pattern of skill development. Onthe one hand, most of the labor force has a low levelof education and, on the other, there is a very limited


89

but highly skilled labor force that competes effectivelyinternationally. Although the average level of educationof the labor force has shown some improvement, thelevel remains very low especially in comparison withEast Asian economies. This dualistic pattern of skillformation emerged partly from an education policythat has been biased since independence against basiceducation and in favor of higher and specialized edu-cation. So, along with labor law reforms, India needsto invest much more heavily and conscientiously inbasic education than it did in the past. Special effortsare needed to improve education quality.

Although the private sector has prospered from thereforms, the public sector has lagged behind sub-stantially owing to the inadequacy of related reforms.That slow response is emerging as a major constraintto growth and human development. The imbalance isshowing up as the inadequate capacity and low effi-ciency of the public sector to address the needs of arapidly transforming modern economy. The public sec-tor’s adaptation to a more deregulated economy andits changing role have shown mixed results. The abilityof the federal government to develop and implementeconomywide reforms shows good progress, as demon-strated by the successful implementation of wide-ranging reforms of the past two and a half decades. Butprogress with policy implementation in many federalagencies and at the state level is mixed. Similarly, pro-gress with the development and implementation ofeffective regulatory actions is also mixed. In regardto direct service delivery, the track record in health,education, water, roads, irrigation, and electricity isweak. Problems include poor efficiency, poor services,


90

weak accountability, and inadequate financial re-sources. Reforms require a major overhaul of theunderlying institutional arrangements for publicservices. That is yet another area of reform challengefor India.

REFERENCES

91

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Index

agricultural labor, income from 22, 23agricultural sector 17

employment in 27growth in 21–23

agriculture 57growth rate of 28role of, in state’s development 30share in Gross State Domestic

Product (GSDP) 29–30and state’s per capita income 30

airline services, financing infrastruc-ture for 88

reforms and progress in 69, 80Andhra Pradesh, growth rate of 28

share of agriculture in, and nationalaverage 30

“attitudinal changes”, and growth41, 42

banks/banking sector, nationalizationof 62

profitability in 64basic education, bias against 89

need for investments in 89policy on 24, 81, 89

Bihar, reliance on agriculture in 29bonus payments 71business, availability of infrastructure

for 66–70cost of doing 57, 61–72financial sector reforms and

62–64impact of deregulation reforms

on 64–65and labor regulations 70–72pro-business approach 41, 42regulatory barriers and 61–62

business community, strength of 15

capital accumulation 42, 75and growth rate 35and rate of investments 35

capital market, for financing busi-ness 64

command-and-control economy 42,43, 82, 83, 86

“command and control” policies 14computer technology, and export of

services 13contract labor, regulation of 72Contract Labor Regulation and

Abolition Act 72crowding out effects 53current account deficits 44, 45, 55

dearness allowance, payment require-ments 71

debt, domestic public 51, 54-to-gross domestic product (GDP)

ratio 51and internal payment obligations 51servicing burden 54

decentralization 73deregulation policy/reforms 86

in faster-growing states 73government initiation of 67impact of 64–65role of 41strategy, and boom in private sector

and higher investments andincome 82

importance of 80development, India’s long-term 45

indicators, of India 33, 34of the world 12strategy, in phase I 86

in phase II 86


98

direct service delivery 83, 89domestic investments, opening up

of 62drinking water, pricing and manage-

ment of 69

economy/economies, of India 11, 16opening of, in India 13structural changes of, and impact

on employment and income oflabor force 22–23

transformation in, and rapid growthin India 75

education(al) 15gap, between male and female

workers 24between rural and urban work-

ers in 24need for reforms in 27, 82outcomes 34policy 24, 81, 89public spending on 81see also basic education, higher

educationelectricity, subsidized, to farmers for

irrigation 68, 69supply and pricing of 68

employment, aggregate growth of, andlabor supply 25creation, low 24and dispute resolution mechanism 72elasticity, of growth 25, 27labor force, and real wages 23–27labor regulation on temporary 72question 17termination, process of 71

entry barriers, reforms and removalof 67

equity, need to improve 34exchange rate, fixed, policy of 49

flexibility in 43, 50, 56, 78management of 53market-based 49

primacy of, for balance of pay-ments stability 47

trends in 48, 50export(s), of goods and services 13, 49,

50, 55growth in 59subsidies 58

external balance 46, 55current account deficit and 44, 45policies for 48–49

external capital flows 35, 37external debt service, burden of 55external payment crisis, of 1990/91 42,

45, 46, 52, 53, 61, 63

factor productivity, and growth rate 35financial sector, control of 43

deregulation in 78reforms 62–64

in phase II 63–64fiscal deficits 51

effects of, on interest rate and privateinvestments 53

financing of current spending 54–55implications on growth 54–55

fiscal management, in faster-growingstates 73

fiscal policy, attaching primacy to, forgrowth 47conduct of 49–55constraints, impact on growth

78–79, 86expansionary 56role of 44

fiscal reforms 80, 88fiscal space, creation of 80, 87, 88foreign direct investment 13, 65foreign investments, in 1998/99 and

2003/04 65opening up of 62prospects for 39

formal sector, employment in 70General Agreement on Tariffs and

Trade (GATT), commitments to 58

REFERENCES

99

government control, on business 61–62gross domestic product (GDP) growth

rate 21, 22share of agriculture in 21, 22share of industries in 21, 22share of services in 21, 22

state-specific 28–31total and per capita 17–20

gross national product (GNP), percapita 20

gross state domestic product (GSDP),per worker in phase II 78share of agriculture in 29–30

growth, acceleration of 11, 18–19, 37accounting 35, 37, 39average rate of 11, 75, 86determinants of 35–39during 1980–90 42experience in phase I (1950–80) 85

in phase II (1980–2004) 85–86and fiscal deficits, during phase I 52long-term, in India 14, 17–33poverty, and human development

31, 33, 34see also growth opportunities

growth opportunities, growth and con-straints 75–83fiscal policy constraints 78–79infrastructure constraints 79–80labor market constraints 80–81public service delivery constraint

82–83skills constraints 81–82

Gujarat, growth rate of 28

Haryana, high growth rate in 28health, quality of 34higher education, policy favoring

81, 89“Hindu growth rate” 14human development, gap between rich

and poor states in 74growth, poverty and 31, 33, 34investments in 78, 79, 87

Imperial Bank of India, nationalizationof 62

import(s) 59–60controls 58, 60

dismantling of 59restrictions on, in phase I 58

import substitution industrialization,government’s support to 58

income, expansion of, in India 85inequalities at state-level 31, 34measurement of 11per capita annual 18and purchasing power parity 11

India, as low-income country 11ranking 12 in world’s economy 85as rapidly growing economy 19role in global economy 85

Industrial Disputes Act of 1947 71,72, 88and constraints on manufacturing

enterprises 81industrial policy 81industrial sector 17, 81

employment in 27growth in 21–22

inflation, containment of, in India 48rate 55real growth and monetary expan-

sion 47, 48trend in, in India 44–45

informal sector 57information technology, India as global

service provider in 85infrastructure, constraints 79–80

development, private financing for67, 88strategy 80

gap between rich and poor states74

investments in 66, 78, 79, 80, 87management, between federal and

state governments 66services, availability of 66–70

institutional reforms 83

INDEX


100

interest rates, government’s control of53, 62deregulation of 63

internal balance 44, 55policies for 47–48

international trade, share of total 11investment(s) 11, 53

deregulation of 43, 78global impact of 11and growth, in states with reform-

minded governments 73in heavy industries 81in highly skilled labor 81in human development 78, 79, 87in infrastructure 66, 78, 79, 80, 87in irrigation water 69licensing, elimination of 62rate and productivity rate, deter-

minants of 41savings and 35–36, 76–77sustained growth rates, and need

for higher 77Investment Climate Assessment 66irrigation water, investment and man-

agement of 69

Karnataka, growth rate of 28

labor (force), absorption 23disputes 72employment and real wages

of 23–27-intensive manufacturing enter-

prises 24, 80–81, 88bias against 82

laws, federal and state 70–71reforms in 88, 89

low education level of 24, 81,88–89

productivity 73regulations 70–72supply, employment and 25

labor market, constraint 80–81

flexibility, need for 27, 88policies 24reforms, lack of 82

lagging regions, need for better policieson infrastructure and human devel-opment 74

liberalization policies 14, 53and implication on growth 41

life insurance business, nationalizationof 62

macroeconomic policies, implicationsof, for growth 55–56

macroeconomic stability 43–56in phase I and phase II 46–47

Madhya Pradesh, share of agriculturein, and national average 30

Maharashtra, growth rate of 28manufacturing sector, constraints on

growth 15, 79–80share of, in output and employ-

ment 23see also labor-intensive manu-

facturingmarkets, access to 57, 58–61

-based incentives 43-oriented reforms and growth

(1980–90) 41, 42wages, in formal sector 71

minimum wages, laws on 70, 71monetary policy, price stability and 47monetization, increase in level of 47money supply, and inflation 47

Narasimhan Committee Report, andimplication of reforms 63

non-trade barriers, policy of, in phase I58

Open General Licensing Scheme, im-ports under 58

Organization for Economic Co-operation and Developmentcountries 86

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101

Orissa, high growth rate in 28reliance on agriculture in 29

per capita income, India’s and Organ-

ization for Economic Co-operation

and Development countries 86states’, dependence on agricul-

ture 30trends, among states in India 32

Planning Commission, role of 83policy framework, for supporting

growth 41–74political constraints, reforms and 15population 11, 14portfolio investment 13ports, financing infrastructure for 88

reforms and progress in 70success in development of 80

poverty, correlation between growthand 34growth and human development

31, 33, 34incidence of 34

power sector, failure of governmentpolicy on 67–68investments in 68see also electricity

price stability 47private investments, increase in 86

monetary policies and 56policies for improving incentives

for 57–72rate, as share of GDP 64–65

private sector, impact of reforms on 89-led economy 42reliance on, for infrastructure

development 67response to incentives by 75

“pro-business” strategy, of govern-ment in phase II 57

productivity growth 41, 78property rights, and security of doing

business 57–58

prudent macroeconomic manage-ment 86

prudent monetary management 78public banking, in rural areas 62, 63public sector, employment in 70

government’s strategy on, in phase I57

lag in 82, 89monopoly 62reforms in 83resources to 53

public service delivery constraint82–83

public spending, efficiency in 79need to improve quality of 87

purchasing power parity 20Punjab, high growth rate in 28

stagnation of growth in 30

Rajasthan, growth rate of 28real wages, labor force, employment

and 23–27trend in 25, 26–27

reforms 15, 78implementation of 89of 1990s 69at state level 73–74and serge in service sector 24

regional patterns of growth 28–31regulatory barriers 61–62remittances, inflow of 36

savings, and investment rates 35–36,76–77rate, national 15

service delivery, need for investmentsand efficiency in 87

service sector 17expanding globally 75export of 13growth in 21–23share in output and employment 23

INDEX


102

skill/skilled, constraint 81–82development 81, 88-intensive growth 23labor force, high 89profile, need to upgrade 27

stabilization, versus growth 49–55state(s), growing differences between

rich and poor 74-level growth performance 28per capita income, dependence on

agriculture 30regulations, impact on growth 73with weak policy performance 74

State Bank of India 62structural changes 75subsidies 55

and price controls, implicationsof 79

sustainable growth 14–15constraints to 75–83

Tamil Nadu, growth rate of 28tariff rates 58, 59tax, collection by federal govern-

ment 79need for appropriate, structure and

administration 78, 87technology transfer 15telecommunications, financing infra-

structure for 88reforms and progress in 69success in development of 80

total factor productivity (TFP) 15,36–39, 60, 61, 76–77contribution to GDP 86improvements in 42

increase in, in phase II 78and long-tern growth 37

trade, controls, and problem in ex-ternal payments 45global impact 11-to-GDP ratio 86liberalization 53, 56, 58, 78

and expansion of private invest-ment and growth 60–61

policy 58evolution of India’s 59

regime, opening of 45–46training 15

need for reforms in 27, 82policy on 24

transport sector, investments andmaintenance of 68–69rail transport and reforms 69road transport, investments in

68–69

unskilled workers 82Uttar Pradesh, reliance on agriculture

in 29

wage board awards 71wage differentials, between male and

female workers 27between states 74

West Bengal, growth rate of 28share of agriculture in, and national

average 30World Trade Organization (WTO),

commitments to 58

REFERENCES

103

About the Author

Sadiq Ahmed is the Sector Director of the Poverty Reduction andEconomic Management Unit of the World Bank. He was educatedat Dhaka University, the London School of Economics, and BostonUniversity. He taught briefly at Dhaka University, was a ResearchEconomist at the Bangladesh Institute of Development Studies,and then joined the World Bank in 1981. At the World Bank heworked in many countries including Egypt, Indonesia, Papua NewGuinea, Thailand, and former Yugoslavia, before moving to theSouth Asia region. He served previously as Country Director forPakistan and Afghanistan and Chief Economist for the SouthAsia region. Since October 2006, he also concur-rently managesthe South Asia Finance and Private Sector Devel-opmentDepartment. His research interests are in areas of macroeconomicpolicy, public finance, trade, and development. He has writtenand published extensively. His last book, Explaining South Asia’sDevelopment Success: The Role of Good Policies was publishedby the World Bank in 2006.

india's long-term growth experience

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