Bill Emmott - International Author & Adviser

Article

The state´s role in India´s growth
Exame - March 2007

What is the secret of economic development? Many of those who studied the success of Japan, South Korea and Taiwan in the 1960s, 70s and 80s, and who now study China, have pointed to the government, or the state. They know that central planning, in the Soviet Union and Mao’s China, did not work. The crucial ingredient, such scholars say, is a “developmental state”, a state capable of directing resources to the areas of the economy that need them most, while using open markets and the price mechanism to maintain competition and discipline. But there is now a big problem with this argument. It is called India. That country is now growing at an annual pace of 9% or more, in real terms. It is rivalling China as a bringer of excitement to global investors and to economists. And yet the growth seems to be happening despite the government, not because of it.

            In fact, it is quite hard to explain why India is growing so rapidly. For three decades before 1980, it grew by an annual average of just 3.5% a year. In the 1980s and 1990s, reforms to reduce regulatory controls and to lower trade barriers helped growth to accelerate to around 6% a year. Since the early 1990s, however, the pace of reform has been slow. The government has made only modest progress in building new infrastructure, for example. Yet during the past three years, without any big new reform or public investment effort, India seems to have raised its growth rate from 6% per year to around 7-8% in 2003-05 and now that 9% figure in the latest year.

            It is easier to describe the improvement than to explain it. What has occurred in India is that private investment has increased rapidly, bringing overall investment to a level of more than 30% of GDP, compared with 23-25% a decade ago, and that investment is being financed mainly by domestic savings, both by households and by a profitable corporate sector. The gross national savings rate has also risen to just over 30% of GDP. That investment level is lower than in China, where it has reached 40% or higher, but Indian investment is arguably much more efficient as more of it is allocated in an open market and with properly functioning price mechanisms.

            India’s economy is currently overheating. So, at least, says my former employer, The Economist, but also so says the Reserve Bank of India, the central bank, which has been raising interest rates to control credit growth and inflation. The inflation rate has risen to about 7%. Capacity utilisation rates in manufacturing industry are approaching 100%. Rapid growth in bank credit has resulted in rapid rises in asset prices, such as equities and real estate.

            Yet although such overheating is a good reason to be cautious about India’s economic prospects in the short term, it does not necessarily mean that the current 9% growth rate is just an illusion. The reason is the high rate of investment, which is almost entirely private rather than public spending. It means that manufacturing capacity is being expanded, that new residential and commercial property is being built, even that new private roads and electricity supply are being built. Today’s supply constraints, which are driving up inflation, can and probably will be overcome. India really does feel as if it is on the move. Indian entrepreneurs gush with confidence, especially as their balance sheets are gushing with capital. They are striding on the world stage, buying up foreign assets such as the Corus steel company in Europe. But they are investing even more in India.

 

Government’s subtler role

On the face of it, India’s current success seems to be happening despite the government, rather than because of it. The prime minister, Dr Manmohan Singh, is a fine economist who as finance minister was the architect of the reforms of the early 1990s, but since taking office in his present job in 2004 he has achieved few of his reform ambitions because his Congress party has had to govern in coalition with a number of anti-reform communist groups.

Thus, the big question presents itself: does India represent a completely different development model to that seen in Japan, Korea and China, led by services rather than goods exports, and occurring without any clear government leadership?

            My sense, after spending most of February in India, is that Asia’s new emerging economic giant is less different than it looks. The reason is twofold: first, that the role of government in Japan, Korea and China has been more subtle than is commonly supposed; and, second, that in India, the government has done more than the current caricature suggests.

            Where the role of government in East Asia and in India converges is that in all those countries the critical contribution made by government has not been planning, or guidance, but rather in the provision of two other important things: stability and flexibility. Outside observers are always keen to detect clever pieces of micro-economic intervention by Asian governments. But actually their most important role has been macro-economic: the maintenance of a firm, anti-inflationary fiscal and monetary framework. Japan’s success in the 1960s and 1970s depended crucially on such stability. So has China’s since 1990: if the government had allowed inflation to get out of control, then it would have scared away not just foreign investors but also domestic ones, and would have deterred ordinary Chinese from saving.

            Flexibility has come from lowering trade barriers and removing regulations that impeded the creation of new businesses. China’s entry into the World Trade Organisation in 2001 was directed exactly at that. Japan was long notorious for its barriers to trade. But in its export-oriented sectors its economy was opened up to competition early on, ensuring that input prices were low and that firms had to measure themselves against the best in the world.

            Contrary to appearances, those have also been the key contributions by India’s government. During the past ten years, successive governments have worked to cut the country’s high budget deficits, lowering the combined deficit of state and central government from 10% of GDP to 6%. The central bank, though not properly independent, has sought to restrain inflation. Bit by bit, more flexibility has been introduced, by steady reductions in tariffs—including in the latest budget, unveiled on February 28th—by reducing the number of sectors reserved for small-scale firms, and by reforming taxes both for companies and for consumers.

            The task is incomplete. It has had to be done in a gradual, rather stealthy way, to avoid provoking controversy and opposition. If India is really to achieve sustained growth of 8-10% a year, the government will have to do more, by transferring its own spending away from wasteful subsidies and towards spending on education, health and infrastructure. That will be hard to do. But in an environment in which private investors have the confidence to invest their capital, it is possible that government too will find it has the chance to use growing tax revenues more constructively than in the past. India has the chance to create a virtuous cycle of growth and governmental reform. It is not a question of either using the state or the market. A developing country needs both.


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