India’s election and its economic future

Having recently overtaken its former colonial master to become the world's fifth-largest economy, India's star certainly appears to be rising. But if the country remains committed to the current government's development strategy, the economy could lose its momentum well before achieving escape velocity.

There is a buzz in India today – a sense of limitless possibilities. If it maintains its current growth rate of 6-7% per year, it will soon overtake stagnant Japan and Germany to take over third place.

But by 2050, India’s workforce will start shrinking, owing to demographic aging. Growth will slow. That means India has only a narrow window in which to grow rich before it grows old: with a per capita income of just $2,500, the economy must grow by 9% per year for the next quarter-century. That is an extremely difficult task, and the current election may well determine whether it remains possible at all.

In pursuit of rapid growth, the Indian government intends to follow a tested road map: the same path that Japan took in the immediate postwar decades, and that China took after the death of Mao Zedong. During the first stage of the journey, labour flows out of the traditional agriculture sector as employment increases in low-skilled manufacturing – typically stitching garments or assembling components into electronic goods. This output is then exported to the developed world to capture the benefits of producing at scale.

Cheap labour helps compensate for a country’s other deficiencies, such as excessive bureaucracy, unreliable power (especially electricity), or poor roads. As firms profit from exports, they invest in equipment to make workers more productive. As those workers are paid more, they can afford better schooling and health care for themselves and their children. Tax revenues also grow, providing the resources to upgrade the country’s infrastructure.

The result is a virtuous cycle, because higher-skilled workers and better infrastructure enable firms to make more sophisticated, higher-value-added products. That is how China has moved from assembling components to producing world-leading electric vehicles in just four decades. Unfortunately, the same strategy is unlikely to work for India today.

It is no accident that India failed to join China in shifting its economy to export-oriented manufacturing, even though the two countries were similarly poor in the late 1970s, when China started on that road. Even low-skilled factory employment requires a minimum level of education and skills. At the time, many Chinese workers met this standard, whereas most Indian workers did not. So, foreign employers found China and its cheap but capable workers more attractive.

Moreover, China’s factory workers acquired skills on the job, and their education allowed them to pick up the basic accounting needed to launch their own small enterprises making products like screws and door handles. This explosion of smaller firms contributed immensely to Chinese growth.

China had other advantages, too. Despite the outward perception of centralized rule by the Communist Party of China, provincial and municipal bosses have wielded a great deal of power. Mayors, hoping to be promoted for generating growth, helped local firms navigate the country’s otherwise-stifling regulations, overriding a rule here and overlooking one there in the name of getting results. By contrast, Indian bureaucracy in the same period was neither decentralized nor incentivized to promote growth, so it instead became an additional burden on Indian business.

Finally, autocratic China could always favour manufacturing in ways that democratic India could not. For example, the Chinese government appropriated land for commercial purposes where necessary; pressured unions to limit wage demands even as labor productivity grew; paid depositors in state-owned banks minimal returns so that the funds could be lent out cheaply to firms; and kept the exchange rate undervalued to maintain local firms’ international competitiveness. In India, attempts to do any of the above would have met fierce democratic resistance.

Nonetheless, the current Indian government wants to get on board the manufacturing bus. With many others looking to diversify away from producing in China, Indian economic policymakers see an opportunity to make up for lost time. Moreover, Indian infrastructure has improved markedly. The country now boasts many world-class airports and ports, increased renewables capacity to bridge power deficits, and an excellent highway system.

But other impediments remain. Over the decade that the Modi administration has been in office, India’s garment exports have grown by less than 5%, while Bangladeshi and Vietnamese garment exports have grown by over 70%, such that their exports are now multiples of India’s. Recognising these continuing impediments, the Indian government has begun offering subsidies to incentivizse production in India, as well as raising tariffs on imports (like cell phones) to enhance these manufacturers’ profits from selling into the now-protected large Indian market.

While it is still early days, one should be skeptical of this strategy. Production-linked subsidies might induce manufacturers to assemble in India, but those firms still will need to import most components. Moreover, margins will be small, because Indian workers now compete with modestly paid Bangladeshi and Vietnamese workers, not with well-paid workers in industrialised countries, as in the past. With little profit for firms to reinvest, and with less tax revenue, net of the subsidy, the virtuous circles needed to move India up the value chain will be much harder to achieve.

Worse, even if the Indian government were to scale up manufacturing, the world is not ready for another China-size exporting powerhouse. Given the widespread shift toward manufacturing protectionism and growing concerns about environmental sustainability, the government’s emphasis on Chinese-style manufacturing-led development seems incompatible with where the world is headed.

There is another way. To drive growth, India could focus on the export of services provided by its well-educated and skilled population. Though this cohort represents a small fraction of the total population, it still numbers in the tens of millions. Such a strategy would build on India’s strengths. The country is already well known for its role in the global software industry, and now it exports many other services, too, accounting for over 5% of the world’s services exports while its goods exports account for less than 2%.

Multinational firms from Goldman Sachs to Rolls-Royce are hiring talented Indian graduates into India-based global capability centres (GCCs), where engineers, architects, consultants, and lawyers create designs, contracts, and content (and software) that are embedded in manufactured goods and services sold globally. These centres already account for over 50% of all GCCs globally, employing 1.66 million Indians and generating $46 billion in annual revenues as of March 2023.

Following the pandemic-induced changes in work habits, and given improvements in communications technology, Indians also have started providing a much wider range of remote services, including consulting, telemedicine, and even yoga instruction. Once a service goes virtual, it matters little whether the provider is ten miles or 10,000 miles away.

An Indian consultant in Hyderabad can now make a presentation to a client in Seattle on behalf of a team whose members span almost every continent. She not only is well trained and fluent in English, she also costs one-fourth of her US counterpart.

True, Indian manufacturing has also benefited from these changes, but this has happened in precisely those areas where engineering, innovation, and design matter more than just the manufacturing process itself. Hence, Agnikul, a Chennai-based firm working to launch small satellites into space, has dispensed entirely with manufacturing supply chains by 3D printing its customised rockets in its own facility.

Tilfi, which sells authentic hand-woven Banarasi silk sarees globally through its website, employs trained designers to create fresh fashions for traditional craftsmen, who in turn are encouraged to embrace innovation.

It would seem to be a no-brainer that India should build on its strength: millions of high-skilled, creative, educated workers, many of whom speak English. Unfortunately, it’s running out of such workers. While India graduates 1.5 million engineers per year, only a minority attend institutions that impart the high-quality education that is in demand at a GCC or a company like Agnikul. Wheebox, a work-skill assessment company, estimates that half of all graduates are unemployable.

Some of these graduates need only a little remedial education to be brought up to speed. But for many Indians, the educational deficiencies run much deeper. While nearly all Indian children start school, fewer than one-quarter can read at a second-grade level by the time they reach third grade. The further behind the stragglers fall, the less sense it makes to stay in school. Many ultimately drop out, incapable of anything but unskilled work. No wonder the share of workers in agriculture is growing in India today, contrary to the usual path for fast-growing countries. India faces a crisis of joblessness today.

So, apart from expanding the creative high-skilled sector, India must create jobs that are broadly targeted at the skills people have. It also needs to improve education and skills, both in the short term and over the long term, so that Indian workers can do the jobs of the future. Sensible reforms would recognize that the solutions to both challenges are related. For example, a study shows that if a government-run daycare employs a part-time worker – perhaps a high-school-educated mother – children’s learning improves significantly. With more than one million such daycares in India today, that is potentially one million more workers set on the road to longer-term employability.

Similarly, public funding for vocational and apprenticeship programs that allow students to cross the threshold of employability could convert millions into productive workers. There is no shortage of demand for health-care providers, plumbers, carpenters, and electricians.

One can find these kinds of proposals in opposition party manifestos. When coupled with reforms to support businesses – especially small- and medium-size firms in labor-intensive sectors like garments, hospitality, and tourism – India could put many more people to work. But this will require carefully designed programs, funded in part by reallocating the tens of billions of dollars now being promised as subsidies to large manufacturers.

In the longer run, there is no alternative to increasing the number and quality of childcare, education, and health-care institutions to capitalize on India’s greatest asset: its people. The currently low level of public spending in these areas should be seen as an opportunity, because it means that there is plenty of room to grow.

India also can draw on its vast diaspora to seed some of the new higher education and research institutions it must create to expand the numbers of the highly skilled. When people have the right skills, and engage with idea-producing institutions, entrepreneurship will create jobs in the most unlikely of places. It wasn’t the government, after all, that created India’s software industry.

Could growing protectionism impede this path? Not necessarily, because high-end services exports are hard to stop at the border if delivered virtually. Moreover, industrialized countries also sell such services globally (think of US management consultants and venture capitalists), which may mean that protectionism in these sectors will be less attractive. And, given their aging populations, industrialized countries have much to gain from India-provided services like telemedicine, since these will reduce the need to attract and assimilate foreign doctors and nurses.

Finally, it is in the rest of the world’s interest if India eschews the Chinese path. If India grows richer faster, it will be able to buy much more from others, and if it grows primarily by producing high-value-added services, this will mitigate the impact on the climate.

There is indeed a way for India to grow rich before it grows old. But it will not be easy, and it will require a change in vision at the top. That, ultimately, is what the ongoing election is about.

© Project Syndicate

Raghuram G Rajan, a former governor of the Reserve Bank of India and chief economist of the International Monetary Fund, is Professor of Finance at the University of Chicago Booth School of Business and the co-author (with Rohit Lamba) of Breaking the Mold: India’s Untraveled Path to Prosperity (Princeton University Press, May 2024).