India's mystifying economic rise bewilders Indians and baffles economists. No one quite understands why this noisy and chaotic democracy of a billion people has become one of the world's fastest growing economies. It is looking at a fourth year of consistent real growth of around 8% a year, following upon 22 years of very respectable 6% average annual growth. What puzzles economists is that India is not following any of the proven paths to success. Compared to the classic Asian strategy—exporting labour-intensive, low-priced manufactured goods to the West—India's economy is driven more by consumption rather than investment, its domestic market rather than exports, services more than industry, and high-tech rather than low-skilled manufacturing.
With consumption accounting for two-thirds of GDP, it is a people friendly model and this why inequality has grown much less in India than in other nations. Its Gini index, which measures income inequality, is 33, compared to 41 for the United States, 45 for China, and 59 for Brazil. (In a perfectly equal society it would be zero.) The domestic orientation has meant that the Indian economy has been far more insulated from global downturns and is less volatile. More importantly, thirty to forty percent of its GDP growth is due to rising total factor productivity rather than mere increase in capital and labour. Ironically, high end manufacturing, which is capital and knowledge intensive, is succeeding, but India is failing to create a broad based industrial revolution based on low end, labour intensive manufacturing. Thus, it is not creating the employment commensurate to its economy's growth. This rightly worries Indians, and they ask: how will India shift its vast army of people from rural to urban areas?
Even more perplexing is that rather than rising with the help of the state, India appears to be rising despite the state. The entrepreneur is clearly at the centre of this success story. India today boasts highly competitive private companies, a booming stock market, and a modern, well-disciplined financial sector. Competitiveness runs deep. More than hundred companies have a market cap of over a billion dollars. Foreign institutions have invested in over 1000 Indian companies via the stock market. Of 500 Fortune companies 125 now have R and D bases in India, and 380 have outsourced software development to India. All this has disciplined the wilful banking sector, whose bad loans are now less than two per cent compared to China's twenty percent (even though India's shoddy state owned banks have not been privatized).
Their economy may mystify Indians but they are agreed on one thing. They are succeeding because their over-regulated state is gradually stepping out of the way. The pace of reform is frustratingly slow, but incredible as it seems, every succeeding government after 1991 has persisted in reforming. Even slow reforms add up, and they have added up to make India the world's fourth-largest economy in terms of purchase power parity and it will soon cross Japan to become the third-largest. During a quarter century of high growth, the middle class has quadrupled to around 250 million, while one percent of the poor have been crossing the poverty line each year, and this too has added up to 200 million people. At the same time, population growth has slowed from the historic rate of 2.2 percent a year to 1.7 percent today—meaning that growth has brought large per capita income gains, from $1,178 in 1980 to $3,051 in 2005 (in purchasing-power parity).
Yet, the Indian state has not lived up to its side of the 1991 bargain. It hasn't built enough good roads, nor given uninterrupted power and water. Government schools and health centres are rotten. The police are corrupt. In short, Indians don't get the services that citizens in other countries take for granted. The Indian state is so riddled with perverse incentives that accountability is impossible. And the irony is that there are so many in this government, supported by their Left allies, who want to bring back state control in the economy and waste hard earned taxes on schemes that will never benefit the poor.
India today stands at the cusp of something big. Growth should not only continue, but accelerate because half the population is below 25, and this can yield a demographic dividend. But it will only happen if it continues to reform. There is a vast, unfinished reform agenda. Public debt is too high, which discourages investment in needed infrastructure. The public sector is sector is still too large (even though much smaller than China's) and uses resources inefficiently, diminishes the potential for employment, and is a drag on growth. Severe labour laws cover only 10 per cent of workers, but once hired they cannot be fired.
What does all this mean for international investors? Unlike China, the Indian state is not particularly friendly and businessmen don't get red carpet treatment. In fact, they have to put up with a frustrating bureaucracy and miles of red tape. It's true that in recent years competition between the Indian states for investment has reduced some of the earlier bureaucratic irritations. While the judiciary may be slow, there is justice at the end. Corporate governance has improved amazingly. Because India opened up late competition in the marketplace is still not severe. Investors report that once established the rewards are large, enduring and more certain. Some companies have said that they are more likely to make profits in India than in China.
What most impresses investors, however, is India's vibrant, positive, and innovative middle class, and this contrasts with the bungling state. International companies have discovered that English speaking Indian employees are highly skilled and their biggest asset. This is why Indians employees have been steadily climbing to the top in many global multinational companies.
India's rise is obviously good news for its billion people. But it is also good news for investors abroad who can benefit from a society which has triumphed over the state. This is a more durable environment for private enterprise. India's rise teaches that rapid economic growth is attainable in a democracy if you get the policies right. Until 1991 India's policies were wrong. India's greatness lies in its self reliant and resilient people, who responded to the reforms. And when the state fails them today, they don't complain. When teachers and doctors don't show up in government primary schools and health centres, they open up cheap private schools and clinics in the slums, and get on with it. The simple lesson is that open societies, free trade and multiplying connections to the global economy are the pathways to lasting prosperity.