How a Great Power Falls Apart
Decline Is Invisible From the Inside
Most developed countries have been struggling with years of slow economic growth. The United States is likely to manage only two or three percent increases in GDP for the foreseeable future. The European Union and Japan would be happy with one percent. In addition, China will report six percent, but that probably translates to true gains of just four percent.
In this company an India that surges seven or eight percent for years to come will stand out. Not surprisingly, such a prospect has won it plenty of international attention, with everyone from Apple’s Tim Cook to the World Bank offering praise.
Yet there is a catch. India’s growth in GDP would constitute a resounding success only if it was labor intensive, involving sustained and large-scale job creation. If not, millions of young Indians entering the labor force will not be able to find decent jobs and growth boasts will be hollow. This problem hasn’t gone unremarked. In mid-2016, Prime Minister Narendra Modi began to embrace the challenge by frequently noting that the Indian economy needed to “transform.” He dropped his previous insistence that “creative incrementalism,” or piecemeal progress, would be enough.
Unfortunately, although solid performance is within easy reach, transformation remains distant. If India is to sprint, not merely jog, New Delhi must allow Indians to be much more productive. That will require easing very restrictive labor market regulations, first and foremost, as well as taking other steps such as permitting full private ownership of land. It is also past time for India to recognize that its people stand to gain far more from open trade than they stand to lose.
Indians certainly do not need to be reminded of this fact, but the rest of the world may: the country is still poor. Policymakers and development experts debate where the poverty line should be and over the value of Indian government statistics in general, but the magnitude of the challenge is clear. Perhaps 250 million people have no access to electricity and an equivalent number have infrequent access. According to the World Bank, India is below the world average in life expectancy; in other words, it fits in more with lower middle-income countries, not global giants.
According to research from Visa, even affluent Indian households earned less than $24,000 annually in 2014 for an average household size of close to five people. The average American household was half the size and earned more than twice that. According to the Indian government, moreover, only one percent of the population was rich enough to pay income taxes in 2013. One reason is that impoverished farmers still make up a large portion of the population. And that is where India’s economic transformation needs to happen.
For these people, short-term growth may or may not be adequate. The government’s reported 7.6 percent GDP growth for the fiscal year 2016 seems healthy, but some analysts worry that the figure has been inflated due to new accounting methods. GDP growth of six percent under the old system was hardly transformative or else Modi would not have won a historic election victory by promising sweeping reform. India either needs to grow considerably faster or it needs to grow considerably differently, with more job creation and personal income gains for the poor.
Here, part of the problem is not necessarily with India, but with GDP. That measure is often used interchangeably with economic growth, which is a serious error. What matters is how ordinary people are faring. In India, such indicators are reported slowly and rarely, with the last full census dating back to 2011. To see how the country is really doing, it is important to look at job creation. On that score, the situation isn’t as encouraging.
By some estimates, ten million people will enter the labor force each year for almost a generation to come.
By some estimates, ten million people will enter the labor force each year for almost a generation to come. Meanwhile, official employment numbers are controversial at best, but discouraging. For instance, in fiscal year 2015, fewer than 65,000 new companies were registered—a trivial number given India’s size. Chinese figures are certainly exaggerated, but numbers of newly registered Chinese firms per year is at least in the millions. Without new employers, job creation is difficult.
According to India’s Labor Bureau, employment growth slowed sharply in 2015 in selected sectors. Formal employment generation in registered entities has been slowing for years. No wonder then, that a recent survey by the Bombay Stock Exchange indicated that urban unemployment stood at 9.6 percent in 2016, where the incoming wave of workers has just started. Rural unemployment was put at “only” 7.2 percent, which likely doesn’t count the tens of millions of people working in extremely low-productivity jobs.
ALL THE WRONG PLACES
Helping to create jobs and raise incomes are the basic tasks for all governments. But Indian policymakers have for years seemed distracted by, first, an obsession with GDP rather than with personal income and, second, excessive concern for the labor market status quo when a massive expansion is looming. Successive Indian governments have protected formal sector workers from free market labor practices while offering the much larger group of informal sector workers little beyond talk. That was unwise before the demographic boom began; it would be disastrous if continued. The Modi government has taken some steps in the right direction, but they are demonstrably short of transformational.
For example, the administration should get credit for the new national goods and services tax. The GST’s final form is yet to be determined, and its implementation may take years. But, eventually, it will boost consumer buying power and cut through the morass of individual state taxes that has prevented India from being a truly unified market and that has been a breeding ground for corruption. A single GST will also help create more and better jobs, especially in logistics.
GST also fits perfectly with the Modi government’s emphasis on making business easier, including making foreign business easier. This is a worthwhile endeavor, but two years in, domestic investment has not yet responded, and even strong growth in foreign investment—in 2015, the figure was already at $40 billion—would be a drop in the bucket, given that India needs to create 10-12 million jobs annually.
Mobilizing domestic and foreign capital to create jobs requires structural reform such as labor and land market liberalization. Instead, the government has preferred fiscal and monetary measures. For one, Finance Minister Arun Jaitley has made calls for interest rate cuts from the start of his tenure. But Indian interest rates are high only in comparison to current international norms, norms associated with poor global economic performance. Fundamentally, a lower interest rate represents discounting of the future by discouraging saving. That undercuts long-term growth and would be an especially poor choice when short-term income growth appears substantial and price inflation has only recently moderated.
The Modi administration has also fretted that banks are not free enough with lending. There is a good reason for banks’ reticence: the quality of their loan portfolios is low. Moreover, distressed assets are concentrated in what most observers consider to be key industries: textiles, steel and other metals, and infrastructure. The banking system in general and the lending relationship with these sectors in particular must be made sound first if growth is to be sustained, not postponed in favor of greater short-term credit.
On the fiscal side, there is no justification for the Modi government to run central deficits well in excess of three percent of GDP annually, particularly as it boasts of world-leading GDP growth. The cause of deficit is subsidies—for example, on food both indirectly and through fertilizers . An economy that features income gains for ordinary people should need proportionately less in the way of subsidies over time. It is too early to demand such reforms of the Modi government, but if the government subsidies tab does not shrink over time, it would signal macroeconomic failure.
If the government makes a political choice to continue to tap savings for subsidies rather than for investment, the drain could be at least partly offset by selling state assets. This will require switching from selling small minority stakes, which Modi has tried and which have not proved attractive even in a bullish market, to giving up control of firms, such as Bharat Heavy Electrical..
Privatizing a major bank such as IDBI would be even better—over 70 percent of Indian bank assets are held by the state. And even private banks are forced to take on burdensome public duties, such as giving mandated loans to farmers. Granting operating licenses to new banks would also be welcome, but could take decades to have a major impact on the state’s strangulation of the financial system. Until then, banking will remain ineffective in supporting growth, in addition to now also being saddled with bad debt.
TOO LITTLE, TOO LATE
Modi’s active policy mistakes are less damaging to India’s long-term economic future than what is not being done. To be sure, passing GST was an endeavor that sapped most energy for other measures. Still, there are vital reforms that are not yet in progress, nor are they being seriously considered.
All discussions of India’s rise start with the country’s young workforce. Yet labor regulations all but guarantee that the workforce will underperform. India’s huge informal economy isn’t going anywhere, with informal labor continuing to face irregular wages, irregular hours, and low productivity. New Delhi could start to address these problems by scrapping the rule that manufacturing firms with more than 100 employees seek government review before laying them off. As it is, manufacturers have a powerful incentive to stay small and keep employment informal. The manufacturing sector cannot lead India forward with that law on the books.
In the aftermath of its GST success, the central government has started to mention the possibility of transformative labor reform. It has done almost nothing of importance to date, leaving the matter to the states. Several have acted, including Rajasthan, which has tripled the 100-employee cutoff point. But even a politically courageous raising of the demarcation line to 300 employees is economically minor, especially when combined with the slow formation of new companies. Government employment—India’s long-preferred method for keeping people off the streets—is expanding nicely. But it won’t absorb tens of millions of underemployed, poor farmers, or create an economic powerhouse.
To take care of those farmers, India needs new jobs, and it also needs land reform. Even in 2016, India is not so far away from feudalism, with land ownership contested by both the state and collective entities such as villages and tribes. That leaves individuals with very little land security, a problem that is punctuated by lack of titles and demarcated boundaries. The last two national governments have attempted to the address this issue but have done more harm than good. Both their land reform acts have emphasized higher compensation for land confiscated from tenants, essentially the thieves offering the victims insurance. Neither act offered farmers any greater degree of true ownership.
India can never become rich if the bulk of its population does not fully own its most precious asset. Farmers who have insecure land rights are naturally less productive. Figures from the previous decade (the latest available) show stagnant per capita food grain production. This is reinforced by a decline in the average size of land holdings to a tiny 1.16 hectares in fiscal 2014.
In addition, contested land ownership thoroughly undermines the idea that India can achieve prosperity through massive amounts of infrastructure spending. Many in New Delhi still cling to this approach despite more than a decade of grand plans that fall short by trillions of rupees. Contested land often delays projects for years or makes them prohibitively expensive. There is no question that India would benefit from better infrastructure, but the state has not been and will not be effective in building it without a proper land market.
Small holdings and insecure ownership make farmers unproductive. With labor market restrictions that discourage formal hiring, unproductive farmers cannot migrate to cities for jobs. This makes the huge labor force more nominal than real and curbs long-term growth potential. Poverty is unavoidable.
Modi recognizes much of this—his Make in India program is a means for the manufacturing sector to absorb farm labor. That program must overcome a slew of domestic policy mistakes. There are also international choices to be made. The government is soliciting multinationals, hoping their investment will bring exports and thus higher wages. But slow international growth has brought with it protectionist pressure in the United States and elsewhere.
To win better access to foreign markets and a competitive position for Indian-made goods and India-based services, New Delhi must offer much greater access to its own market to its highly valued economic partners. China’s demographics a generation ago resembled India’s now. At the time, China undertook an aggressive campaign to trade genuine domestic reform for guaranteed global market access. The benefits were enormous. In stark contrast, India remains arguably the major country most hostile to making domestic change for the sake of global trade.
WHAT IS TO BE DONE?
The Modi government has taken the equivalent of two steps forward. It needs four or five more. First, it must liberalize the manufacturing labor market. Pronouncements about India’s rise alone will not expand employment. The single most important step is to progressively raise the threshold at which manufacturing firms can hire and fire without government interference. The faster and more broadly this happens, the sooner India will actually be able deploy its huge pool of workers and become the manufacturing powerhouse it can and needs to be.
Second, India must protect individual land ownership. Permanently granting land rights to people who desperately need them requires demarcation and registration first. This is a huge task that is decades overdue, and the response to pilot projects in several states has been immediate and enthusiastic. Once the labor market is ready to absorb underemployed farmers, much of the rest of rural poverty can be eradicated by the right to fully own one’s land.
Third, India will have to privatize some banks. New banks cannot draw customers fast enough to transform the financial system in the next decade. Although the state will continue to have a major role, the state share of banking assets should be quickly reduced to 50 percent through sales to approved private investors. This will improve financial intermediation and buttress economic growth. A secondary benefit: it will allow the government to continue certain popular subsidies without diverting capital from more productive uses.
Fourth, India will have to shift its trade policies. The country cannot rely on globalization to proceed automatically. The national government should offer its most important partners reciprocal and sharp improvements in market access. The first partner to overcome any of its own domestic opposition will benefit the most from Indian expansion. Others will be pushed to follow, and jobs, wages, and profits will increase in India.
These are difficult actions, and opponents will no doubt argue that India can perform decently without them. This might be true, but decent is not transformative. Decent is GDP growth that India can brag about but that does not create good jobs for informal sector workers. Decent is preserving the status quo in banking and trade when that status quo performance is obviously substandard. Decent is still hoping that the monsoon allows prosperity. Transformation is possible if India is willing to do more.