From the late 1960s through the early 1990s, Anne Krueger visited India about every five years. Each trip left her feeling like “an inverse Rip Van Winkle,” she recalls. The restaurants and hotels were always the same. Nothing else changed, either. India’s economy was growing at a snail’s pace, as it had been since independence in 1947. No matter what various governments tried, the growth rate stubbornly refused to budge above 3.5% — a problem commonly derided as the “Hindu Rate of Growth.”
Now, of course, everything is changing — including a dramatic increase in growth. Indian economists brag that GDP growth — which hovers around 9% — could rise higher. On April 26, the Swiss bank Credit Suisse noted in a report that India is now among 12 countries in the world whose GDP exceeds $1 trillion. Despite all this good news, however, numerous problems remain, according to Krueger, first deputy managing director of the International Monetary Fund from 2001 through last August. “Starting in 1991 there was something different,” Krueger says. “I didn’t feel quite as at home. Things were changing at an accelerating rate.”
Krueger spoke about India’s economic evolution in her April 20 keynote address at a conference on India’s Financial System organized by Wharton’s Financial Institutions Center with the Centre for Analytical Finance at the Indian School of Business in Hyderabad and the Stockholm-based Swedish Institute for Financial Research. On May 1 she became professor of international economics at the School for Advanced International Studies at Johns Hopkins University. “Perhaps the most striking feature of the conference was that it was a truly global event,” says Sankar De, executive director of the Centre for Analytical Finance. “It was a conference on India’s financial market held in the United States and co-organized by research centers located on three different continents.”
How did India escape its long-standing stagnation? “In the early 1980s, there was an attempt to get out of this by expanding government expenditures,” Krueger notes. While this was somewhat successful, economic stimulation through government spending was unsustainable. India suffered a mushrooming of its current account deficit, which includes factors such as the excess of imports over exports. Part of the pressure on balance of payments was caused by the fact that in the 1970s, India faced massive oil import costs following the OPEC price hikes, forcing the country to borrow more than $5 billion from the IMF. The heavy spending also drove the government’s annual budget deficit to a dangerously high level equal to 6.6% of gross domestic product, she said. Many state governments also ran deficits.
The improving growth rate of the 1980s therefore came at the expense of the future, according to Krueger. With that factor taken into account, the 1980s actually did not provide any real economic improvement. “There was a crisis again in 1991,” she recalls. “There was an effort to start reforms.” The need for reforms was forced upon India by the fact that the country had just a few weeks worth of foreign exchange left at the time. The Narasimha Rao government, whose finance minister was Manmohan Singh — India’s present prime minister — moved swiftly to open up the economy.
Soon, restrictions were removed from the rupee, trade restrictions were eased, and there was fiscal and regulatory reform. Fortunately, India already had a stock market that functioned fairly well. “The economy did respond,” Krueger says. “There’s absolutely no question about it.” By the early 1990s, India’s economy was growing at a strong annual rate of 6%, and per capita income growth went from 1.5% a year to 4.2% — a huge increase.
The pace has continued to accelerate. Growth is expected to top 9% for the fiscal year ended March 31. “Things are really on the move,” Krueger notes. Today, capital is flowing into the country and the rupee is easily exchanged for other currencies. “There’s a lot on the positive side,” she adds. “The message is, the outlook is good, as of now. But unless some more things happen, there are still some issues…. India is still at a very early stage of development, by any measure.”
About 60% of India’s population remains in rural areas largely dependent on agriculture, while the figure is a tiny fraction of that in developed countries. Typically a developing economy moves from an agricultural base to a heavy emphasis on manufacturing. But in India, the service sector is growing faster than manufacturing.
“We’ve never seen that before,” Krueger says. Services such as back-office outsourcing and other business services are growing faster, in part because they face less governmental regulation than do other businesses. “The success of outsourcing and software development … shows what India’s potential is. The good news is that services are booming. The bad news is that this reflects what India could do elsewhere but is not doing.”
At the same time, agricultural development is stagnating — growing slower than the 3.5% annual rates of the 1980s and 1990s. The sector soaks up huge government subsidies, equal to 1.5% of gross domestic product, but receives little other investment. “Agriculture’s relative stagnation is a cause for concern,” she says.
Although industrial production is growing, much of it involves labor-saving investment. Employment is falling in many areas. Compared to China, which is growing very rapidly, India is bound by heavy unionization and labor-protecting laws that are more severe for larger firms. This has discouraged creation of the kind of large-scale industrial firms that have been crucial to the economic success of China and South Korea, she says. “The employment situation is not pretty, and it needs, I think, the most urgent attention.”
Another worry, according to Krueger, is the fiscal deficit, running at about 4.5% of GDP for the central government and 2.5% to 3% for various states. The cost is heavy, with interest rates on debt averaging a high 8.5%, she said. “Inflationary pressures mean that is certainly not going to fall,” she adds. High inflation is also a problem. It is about 5.5% a year and rising. Krueger believes that is worrisome in itself, but the problem is compounded by the government’s heavy influence on lending. About 43% of credit is directed to borrowers designated by the government.
“The banking system does not work like a banking system,” Krueger says, noting that it “is subject to very stringent rules and regulations.” This recalls the disastrous use of directed credit by South Korea, which emphasized lending to agriculture and exports. It worked initially but brought on a financial crisis in the 1990s, when investment returns fell below zero. “As an economy grows, the importance of allocating capital correctly increases. It becomes less and less likely that the government will choose the right borrowers. India should provide more credit to manufacturing. Going forward there’s no doubt that India needs a less restrictive financial sector with much less directed credit,” she says.
Krueger believes that India faces additional problems with its antiquated and worn-down infrastructure. Because the government must allocate 30% of revenues to interest payments on debt, it does not have enough money to fix roads, railways and other facilities, she says, recalling a 170-mile trip that took her six hours. It’s common to take two weeks for a journey that would take two days in the U.S. “These kinds of things add to [business] costs enormously.”
Despite some regulatory reform, heavy government controls hinder economic growth, she says, noting that India ranked 122nd out of 176 in a World Bank index for ease of doing business. Widespread, government-protected unionization is a problem — not so much because of minimum-wage and pension requirements but because a constant threat of strikes means companies rarely “get control of the production process in any meaningful way,” she says. Unfortunately, unions are intertwined with politics, and the government seems to have little stomach for resolving the problems. “The political atmosphere is not entirely reassuring.”
On the other hand, Krueger notes a cause for optimism not found in many other developing countries, where reversals are common: In India, economic advances tend to stick. “We’ve had very good steps so far,” she says. “India has done a lot. It hasn’t always been easy. But there’s a lot to be done.”