qp / / g india: a growth model in...

May 2006 Conjoncture 14

The acceleration in Indian growth has been slow butsteady since the country fully committed itself toderegulating the economy in the 1980s. Prudence

and pragmatism from successive governments have beenrequired to move from a growth model based on self-sufficiency to one of openness to foreign trade, given thesize of the country, its regional, social and economicdifferences and the limited financial leeway available to theState. The new millennium has started under the bestauspices with annual GDP growth close to 8%(1) since2003/04(2), compared with 3.5% over the first three decadesafter independence. Despite a chronic lack of infrastructureand high oil prices in the past couple of years, the currentperiod of expansion is the strongest and lengthiest that theIndian economy has experienced. Is it entirely attributableto a cyclical effect and the strength of tertiary activity or doesit result from structural progress benefiting the whole of theeconomy? How do we explain the industrial investmentupturn?

With the slowdown in demographic growth, theacceleration in the rate of economic expansion hasraised average living standards. However, thisacceleration has largely been due to productivity gains,which are not conducive to mass job creation.Furthermore, economic liberalisation has led to greaterinequalities of income, whether between regions or thedifferent social classes. Poverty may have fallen overallbut vast inequalities remain between the various levels ofsociety, between urban and rural areas, and betweenstates, making it difficult to make any generalassessment. Given the influx of young generations onthe labour market over the next few decades, the majorproblem shaping up is that of employment, with all itsrepercussions on urban migration and the potential riskof a social crisis. To what extent have the original choicesof the Indian route to development been unable to raisehopes of the economic structure being better suited to

demographic growth, most notably through a moreambitious development of labour intensive industries?Are the new growth pattern and reforms leading to arebalancing?

An ascending growth trajectory

The monsoon of structural reform

Current reforms – implemented 25 years ago andstepped up following the balance of payments crisis in1991 – have been paramount in speeding up economicgrowth. Whereas, at the time of the planning and importsubstitution system from the 1950s to the late 1970s,annual growth averaged 3.5%(3), GDP rose by an averageof 5.6% per annum between 1980/81 and 1989/90, then5.8% a year between 1990/91 and 1999/00. Averagegrowth this decade stands at 6.6% despite three years ofmediocre figures from 2000/01 to 2002/03 (see Table 1,page 15). Other fundamental measures of growth reflectthe upturn. For example, average growth in per capitalabour productivity accelerated from 0.7% a year in the1970s to 3.9% in the 1980s, remaining high at 3.3% in the1990s. Over the same timescale, growth in total factorproductivity rose from -0.5% per annum to 2.5% beforesettling at 1.6%.

The same party in Congress – the dominant force inIndian political life from independence to the mid-1990s(with the arrival of coalition governments) – was behindthe economic policies applied over the first threedecades after independence and the two waves ofreform in the 1980s and 1990s, under differentcircumstances. This progress illustrates the fundamentalchange in mentality within the party in response to thedifficulties encountered.

India: a growth model in transitionDelphine Cavalier

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At the start of the 1980s, the important thing was tospeed up the low rate of economic growth that India hadsystematically recorded since independence. In seekingto improve the living standards of the population whenfaced with the deterioration in poverty indicators, IndiraGandhi’s government was also looking to stop itsleadership from crumbling. The state of emergency in1976 and the election results of the following year hadbeen catastrophic for the Congress. They marked thedilution of political power between central governmentand individual states, i.e between Congress and risingstate parties, and began the process of economicdecentralisation.

Subsequently, the widening of budget and tradedeficits undermined the financing of the Indian economy,which was thus unable to absorb the dual crisis of thecollapse of the USSR (India’s leading trade partner at thetime) and the Gulf War (oil crisis and loss of foreign-exchange earnings from overseas workers in the MiddleEast) at the start of the 1990s. Low currency reservesmade it necessary for the government to adopt astructural adjustment proposal from the IMF and WorldBank to improve production apparatus and the growthrate, mainly by opening up to foreign trade.

Industrial deregulation

Reform undertaken in the 1980s involved regulationson the environment in which industrial enterprisesoperate, through the stage-by-stage dismantlement ofthe Licence Raj, the system of receiving priorauthorisation for investment, importations of capital andintermediate goods, and business diversification. Othermeasures and reforms accompanied this process:devaluation of the rupee; extension of export taxincentives; improved access to credit and foreigncurrencies; liberalisation of administered prices oncertain key inputs inputs required for industrialproduction.

Opening up of the economy

Initial reforms continued the following decade with,in particular, the total abolition of the requirement toobtain prior authorisation to invest in industry. The

difficult financial backdrop during the balance ofpayments crisis encouraged a second wave of reformextended to the services sector and aimed at graduallyopening up the economy: restriction of the number ofpublic monopolies (process of public disinvestmentfrom 1994); opening of services for which public sectorcontrol was strong, such as banking, insurance andcommunications; financial liberalisation (removal ofcontrols on corporate capital issues on the domesticfinancial markets, relaxation of lending conditions,simplification of the interest rate structure and itsdetermination by the market, see Chart 1); gradualliberalisation of foreign investment (direct and portfolio);liberalisation of external trade (total abolition ofrequirement to obtain permission to import, gradualreduction in import duties). Industrial policy alsounderwent a major overhaul with the process of “de-reserving” sectors of small-scale industry that hadhitherto been protected and unrivalled (see Insert 1,page 16).


Real GDP growth (%)

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1980/81 to1989/90

1990/91 to1999/00

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Real GDP 3.5 5.6 5.8 6.6

Table 1 Source: IFI

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Chart 1 Sources: Ecowin, CEIC

Prime lending rate

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Structural decrease in interest rates

and banks' mandatory ratios

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* CRRR: share of domestic deposit liabilities that banks mustmaintain with the central bank.** SLR: share of deposits that banks are mandated to invest in T-bills and bonds.

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We witnessed the first wave of reform as a period ofinternal preparation that preceded the move to open upto international competition. Initial conditions played adecisive role. Favourable underlying factors (limitedinflation, ratio of public debt to GDP, pre-existence of astrong private sector, role of a market economyalongside a strong government, well-established legalsystem, stable democratic institutions, fairly developedfinancial sector despite an inefficient use of capital) madeIndia relatively receptive to the changes that would occurin some Latin American and Eastern European countriesengaged in similar reforms over the same period.

However, some parts of the economy remainuntouched by the reform process, as their reformwould be socially and politically sensitive, especiallyconcerning laws governing the labour market forlarge enterprises – these are considered rigid and notconducive to employment in the formal sector – andthe fairly high number of sectors reserved for small-scale industry. Moreover, the Singh government hasslashed public disinvestment targets over the last twoyears, submitting to the common coalitionprogramme that enjoys communist support inparliament.


Insert 1: The Indian job market – adverse effects of labour laws and industrial policy in small-scale industry

A two-tier job market that distinguishes between companiesIn India, labour is essentially concentrated on the unorganised sector – sometimes called “informal” or “unregistered” (i.e.

without any employment contracts or social security in businesses with less than 10 employees) – which is not subject totaxation. Due to the logistical difficulty in calculating figures, there are no regularly published statistics on informal employment.The only information available comes from the five-year survey carried out by the Indian government’s National SampleSurvey Organisation. According to this, informal employment accounts for around 92% of the total. As for legislation governingemployment in the formal sector (less than 10% of the total workforce) – companies with 100 employees or more must obtainpermission from the state authorities to make redundancies.

Reservation policy for small-scale industry To encourage the development of a labour-intensive manufacturing sector in the 1950s, the government introduced a

series of benefits for small-scale industries (SSI), which are defined as companies with a maximum of 10 employees or havinga reduced credit limit. In particular, these benefits involved the reservation of entire business sectors, tax exemptions,preferential access to loans with subsidised rates of interest, and a public sector buying policy that guarantees productionoutlets.

Small-scale industry gradually gained exclusive control of whole production sectors: 837 at its peak in 1983, i.e. around7,500 products, the vast majority of which were in the textile, vehicle parts, food and cosmetics sectors. SSI actually hassomething of a dual nature itself, with a traditional, artisan-type element, which uses little or no machinery, and a moderncomponent that accounts for nearly 75% of production but only one third of employment. Its rapid growth under the cover ofreserved items and employment regulations (sometimes justifying the excesses) has led to the emergence of specialisedclusters. There are several hundred of these hosting modern SMEs, many of which are subcontractors for large industry, whichhas found a way of sidestepping fairly rigid labour legislation in the organised sector.

The liberalisation of the economy has, however, resulted in realisation that the reservation system has adverse affects andin the absence of earnings objectives and foreign competition, these have led to sub-optimal quality, labour conditions andeconomies of scale. A gradual de-reservation movement began in 1997, such that the number of reserved sectors had fallento 605 in October 2004(*). However, there is widespread public and political resistance and the change in the industriallandscape will probably be slow.

(*) The list of reserved sectors can be found at the following address: www.smallindustryindia.com/ssiindia/reservitems.html

Sources: Boillot (2006), CRISIL (2006), IMF (2006b).

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The godsend of a prosperous global and domesticeconomy

It is the positive combination of domestic andinternational cyclical factors that appears to explainunderlying economic trends. Helped by reform, these were already contributing to the structuralconsolidation of the economy on the supply anddemand sides. At a domestic level, the monsoon,which is an inevitable input ofn Indian GDP(4), wasexceptional in 2003/04 and this helped shore upconsumer spending, which is the traditional basis forIndian growth. It triggered a virtuous circle ofdemand-production-investment at a time whenindustrial enterprises were coming to the end ofseveral years of restructuring. At a global level, thebackdrop of excess liquidity prevalent over the lastfour years has squeezed risk premiums tounprecedented levels, prompting internationalinvestors to seek higher yields in lower-ratedemerging countries(5). Under the circumstances,substantial flows of overseas capital into India – helped by the craze for large emerging countries –have played an increasing role in financing theeconomy over recent years. This has generally led toan improved, more balanced, growth pattern.

A more balanced growth pattern

The tertiary sector continues to fuel the Indianeconomy but we now have confirmation of theindustrial recovery that has been ongoing for threeyears. In the third quarter of 2005/06 (October-December 2005), year-on-year core GDP growth(i.e. excluding farming) came out above 7.5% forthe ninth consecutive quarter – an unprecedentedlevel of strength. The contribution from industrywas again much lower than that from services butit has been rising constantly for four years.Services and industry form a solid basis for growthover the coming years, to the extent that they willreduce the Indian economy’s vulnerability to thepersistent volatility of farm production (see Chart 2).

Structural improvement of supply ...

Services leading the way

India is a tertiary economy, drawing most of itsstrength from services since the 1990s. In 2000, theseaccounted for 49% of GDP versus 37% in 1980. Growthoutstripped that of industry in the 1980s with an averageof 6.6% per year, and the following decade with 7.5% peryear. Covering around 26% of total employment, Indianservices can boast a remarkable performance in terms ofunit labour costs. Far from being limited to IT services(6)

and business process outsourcing(7), which account for2% of GDP, i.e. 4% of total services, the tertiary sectordraws strength from the whole range of modern services.Growth drivers are primarily domestic, due to factorresources (poor national infrastructures and poor accessto capital until recently, but plentiful supply of qualifiedlabour(8) thanks to low job starts in industry) andliberalisation (banks, insurance companies and private-sector communications). At a global level, the ITrevolution encouraged the wave of offshore BPO thatmostly benefited the whole of to India thanks to its humancapital.

In recent years, services growth has received an extraboost to reach 8-9% per annum and account for morethan 65% of GDP growth. Two types of services haveexpanded particularly quickly: financial services; andservices linked to trade, hotels and restaurants, transportand communications. The former have benefited fromthe rise in the equity markets (trading, M& A(9), etc.), the


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Erratic growth in agriculture

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strength of retail banking (consumer credit, vehicle loansand mortgages) and asset management that reflects theemergence of a well-off Asian middle class. The secondrelates to the increase in retail sales and tourism, and tostiffer competition in the telecom sector.

Industry has re-established itself

The industrial sector is small for an economy at thisstage of its development, with a contribution to GDPlimited to 27% – stable since the early 1990s – and uponly slightly on 1980 (24%). The manufacturing sectordominates at around 80% with the mining sector (10%)and electricity (10%) accounting for the rest. Half ofmanufacturing production has traditionally boiled down tosix sectors (chemicals, non-transport machinery andequipment, food products, base metals and alloys,rubber-based products, plastics, oil and coal, cottontextiles) with chemicals easily dominating(10) (20% of thetotal). Industrial output is concentrated on base products(36%), intermediate goods (27%) and non-durableconsumer goods (23%). Capital goods account for just9.3% of the total.

Manufacturing output has been undergoing a freshwave of acceleration since mid-2001/02. In annual data,the index has gained 8.1% a year between 2002/03 and2005/06, compared with 5.1% between 1998/99 and2001/02. This is largely due to machinery andequipment (including transport), drinks and tobacco,chemicals and textiles (including ready-to-wear).Production is thus rising on the back of capital andconsumer goods (see Chart 3). Among infrastructure-related industries, steel, refined petroleum and cement,which are present on the export market, are particularlystrong thanks to world prices. In contrast, the chroniccounter-performance of the electricity sector, with itspublic monopoly, reflects the obsolescence of plants dueto a lack of investment.

Admittedly, manufacturing production in the currentcycle has not reached the level of the 1990s (9.3% ayear on average between 1993/94 and 1997/98) whenthere was an investment boom. However, it seems morerobust as it is based on real effective demand – domestic (final consumption and investment) andforeign – whose strength requires the extension or

creation of new production capacities, as the sharpincrease in capital goods production and importsdemonstrates (see Chart 4). In contrast, the investmentcycle of the 1990s proved short-lived as it relied onoverly optimistic demand forecasts. The current upturnin capital expenditure is particularly marked asbusinesses have emerged stronger from a period ofdraconian restructuring that has enabled them to restoreprofitability and improve competitiveness (see Insert 2,page 19).

Persistent volatility in farm production, but lesserimpact on the rest of the economy

Despite the reduction in its percentage of GDP(24%), the farm sector still accounts for more thanhalf of the total workforce. In 2005/06, the primary


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Chart 3 Source: CEIC

Drivers of manufacturing production:

capital and consumer goods

consumer goods (29 %)

capital goods (9% of the total index)

Manufacturing production index

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sector registered its third consecutive year of growth.The exceptional monsoon of 2003/04 led to a record9.6% increase in production, the sharpest since1996/97. Since then we have seen more modestperformances but they have nevertheless beenpositive (1.1% in 2004/05 then 2.5% expected in2005/06). Harvests remain highly sensitive to theregional distribution of rain and its timing(11) due to thepoor coverage of irrigated surfaces (40% of cultivableland), especially as storage infrastructures are of poorquality. The great drought of 2002/03 caused a 7%decline in farm production, resulting in a slowdown forthe economy as a whole, with GDP growth limited to4.1%. The direct route by which a poor monsoonfilters through to the rest of the economy involvesconsumer spending but some industries can sufferindirectly and at a later date. Each year, agricultureintroduces a significant degree of uncertaintyconcerning GDP growth but the rapid expansion ofthe industrial sector through its new outlets ondomestic and international markets may help tostabilise the economy, reducing the dependence ofdomestic demand on farm production.

…and of domestic and foreign demand

Structural increase in consumer spending

Given the size of the domestic market, consumerdemand is the primary growth driver. The spectacularrise in non-oil imports from 2002/03 to the end of 2004/05(peaking at 70% y/y in March 2005) and the accelerationin durable and non-durable consumer goods productionsince 2003/04 suggest an enhanced consumptiondynamics despite the slight deceleration at the end of2005/06. The general strengthening of consumerdemand relates to major structural changes, which tendto reduce dependence on farm revenues: emergence ofa middle class – result of the sharp rise in income percapita over the last 10 years – and increase in thepercentage of the working-age population in the totalpopulation. In addition, the structural fall in interest ratesand wider availability of bank credit have improvedhouseholds’ access to mass consumption. Revenueeffect, consumerism and demographic trends havecombined to increase individuals’ spending, whilechanging the breakdown thereof.


Insert 2: the manufacturing sector is recovering after the trough of the mid-1990s

When, after the balance of payments crisis in 1991/92, the Indian government decided to open up the economy, notablyby lowering import taxes, protection for Indian businesses on the domestic market suddenly came into doubt. Some customsduties on imported goods stood above 100% before the country opened up, compared with an average of around 14.5% today.

To ward off competition on their own market and being sure that domestic demand would rise quickly, local businessesspent considerable amounts on capital to increase production capacities. However, their forecasts regarding private demandproved unrealistic (several farming recessions, in 1991/92, 1995/96 and 1997/98). The central bank also made the mistake oftightening monetary policy too extensively and quickly to curb inflation and credit growth. The annual change in wholesaleprices virtually doubled between early 1993 and early 1994, rising from 7% to 12%. The prime lending rate from commercialbanks climbed from 14% to 16.5% between January 1995 and January 1996. In response, credit and manufacturing outputsuffered a downturn, plunging Indian industry into a six-year period of sluggishness (1996/97-2001/02).

Domestic restructuring was necessary to absorb surplus investment. This was made easier by the continued reduction inproduction costs linked to monetary easing (new easing monetary policy cycle from July 1996), deregulation of the domesticmarket (lower cost of capital and imports) and a reduction in overstaffing thanks to voluntary retirement schemes. These madeit possible to sidestep employment legislation, which still makes it difficult for companies with more than 100 employees tomake redundancies. Between 1996 and 2003, the manufacturing industry lost four million jobs, i.e. 20% of its workforce.

In-house reorganisations of production and management teams, and the spread of information technology in productionand management techniques helped raise productivity. This resulted in an improvement in the financial health of businesses(profitability, deleveraging) and, more generally, in competitiveness, enabling the largest enterprises to concentrate more onthe export market.Source: mission in Mumbai (January 2006).

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Rise in GDP per capita

Poverty indicators have improved over the last 10 years but India remains a very poor country. Thepercentage of the population living below the povertythreshold was estimated at 29% in 1999/00, comparedwith 36% in 1993/94. Moreover, income disparities havewidened with liberalisation(12). For all that, a faster rate ofeconomic expansion and slower demographic growth(from 2.1% per year at the start of the 1990s to around1.7% now) have led to an unprecedented increase inGDP per capita. At USD 635 in 2004/05, real GDP percapita has climbed nearly 80% in the space of 10 years(see Chart 5).

Demographic transition

India is a young country with an average age ofapproximately 24 years, compared with 32 in China or34 in South Korea. Indian demographic transition isseveral years behind the rest of the Asian continent.Since the beginning of the 1990s, India has experiencedswift growth in the ratio of the working-age population(15-64 year olds deemed as the potential workforce) tothe total, automatically reducing the dependency ratio ofthe young age groups and the over-65s to the workingpopulation. Indian growth thus enjoys a kind of“demographic dividend”. The working-age populationwas estimated at 690 million in 2005. It could reach 760million in 2010, meaning an annual increase of 14million. It should continue to rise until 2045, pushing thepercentage of 15-64 year olds in the total population upfrom 63% today to 68%. Demographic pressure has sofar been managed by the controlled increase in thelabour participation rate (ratio of the working populationto the working-age population), notably by restrictinggrowth in female workers. However, this rate is still likelyto rise.

Demography and internal migrations from rural tourban areas should also have a deep impact on theeconomic footprint of India over the next 20 years.The percentage of the rural population in the total isstill more than 65% but the United Nations estimatesthat the urban population should account for morethan half of the total by 2025-2030. The population of

the main cities will have risen significantly on thistimescale: Delhi (40 million), Mumbai (30-35 million),Kolkata (20-25 million), Bangalore, Surat,Hyderabad, Chennai, Puna, Ahmedabad (10-15million each), Jaipur (7 million), Lucknow (5 million).Current urban infrastructures are not ready for sucha shock.

Reality of the Indian middle class

Income growth and the enlargement of the middleclass have helped raise purchasing power. There aredifferent ways of defining the Indian middle class. Wehave used the NCAER’s (National Council for AppliedEconomic Research), which includes households withan annual income of between 200,000 and 1 millionrupees (i.e. USD 4,000-23,000). In 2001/02,11 million households (or 57 million individuals), i.e.6% of the national total, belonged to this group. Thepercentage has doubled in six years and should reach13% on a 2009/10 horizon (28 million households,160 million individuals) (see Table 2, page 21).However, certain specialised enterprises in thesegment of consumer goods target a more or lesslarge population depending on the products they sell.Bearing in mind that with annual income of USD3,000 it is possible to buy a car, the middle class inthe broader sense is more like 300 millionindividuals, i.e. a little more than the population of theUnited States.


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Average growth

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The income effect doubles with a wealth effect arisingfrom greater ownership of shares (the percentage ofhousehold savings held in shares is estimated at 20%)and a booming stock market (+74% y/y in March 2006 forthe Mumbai marketplace). Furthermore, the strength ofconsumer lending gives the impression that massconsumption is more accessible. According to the Fitchrating agency, consumer credit rose by an average of40% per year between 2000 and 2005. It accounts for24% of total outstanding bank loans, compared with 11%in 1999/00, but only 10% of GDP.

Retail trade boom shaping up

We can expect major growth in retail trade, whichshould lead to an increase in the market share ofshopping centres at the expense of small traditionalbusinesses and therefore employment. The retailtrade sector (10% of GDP) is actually the secondmainstay of the Indian economy in terms of jobs (21 million), behind farming. Almost entirelyunorganised, this sector includes a multitude of“mom-and-pop corner shops”. These represent thebulk of the market due to their unrivalled proximity tovastly different segments of the population from oneregion to the next, with specific requirements that theycan best meet. However, while young Indians arebecoming receptive to new consumption formats,those seeking more elaborate, better quality goodsmay find this method of retailing unsatisfactory. Themarket share of specialist shopping centres andfranchises is growing rapidly. Despite fierceresistance from traditional commerce to thiscompetition, at the beginning of 2005 the governmentauthorised foreign investment of up to 51% in single-brand stores.

Impact of the demographic dividend on savings dynamics

Growth in the working population has amacroeconomic impact on savings trends. The workingpopulation has a greater propensity to save thandependent people – the under 15s and over 65s alike. Asa result, an increase in the savings rate (savings/GDP)increases the investment rate (GFCF/GDP), encouraging

the development of a virtuous growth circle (see Chart 6). At the start of the 1980s, the gross savings ratefor the Indian economy as a whole was around 20%.Except for the period of decline noted over the secondhalf of the 1990s, this rate has climbed non-stop to reach28% in 2003/04 according to central bank statistics. Thebreakdown of these savings has changed. The dip inpublic savings has been offset by an increase in thepercentage of household and corporate savings. Theweight of household savings in the total rose from anaverage of 74% in the 1980s to 83% from the 1990s to2003/04. For private enterprises, the proportion rosefrom 9% to 16%. Meanwhile, the percentage of publicsavings slumped from 17% to 1%. The public sector hasactually been registering a negative savings rate since1998/99.


Distribution of annual household income (rupees)

1995/96 2001/02 2009/10p Less than 90,000 131,176 135,378 114,395 90,000 – 200,000 28,901 41,262 75,304 200,000 – 500,000 3,881 9,034 22,268 500,000 – 1 million 651 1,712 6,173 1–2 million 189 546 2,373 2–5 million 63 201 1,037 5–10 million 11 40 255 More than 10 million 5 20 141 Number of households (millions) 165 188 222 Percentage of middle class households 2.7 % 5.7 % 12.8 %

Table 2 Sources: NCAER, JP Morgan

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The investment cycle is well underway

A more vigorous investment cycle than before(1993/94-1995/96) began in 2001/02. According to thenational accounts, growth in the volume of privateenterprises’ gross fixed capital formation acceleratedconstantly between 2001/02 and 2004/05, pushingproductive investment up from 24% of GDP to 26% (see Chart 7). Various industrial surveys (NCAER,Confederation of Indian Industry, Dun & Bradstreet)report the rapid saturation of production capacities due tostrong growth in domestic demand, as we saw earlier,but more particularly foreign demand as reflected in theupsurge in manufactured goods exports since thebeginning of 2002/03.

The pick-up in investment has come about withoutany obvious acceleration in foreign direct investment(FDI), unlike the situation for various Asian economiesduring their periods of industrialisation and economictake-off. Annual FDI flows into India remain limited tounder 1% of GDP, even if they have been growing slightlymore quickly since the start of the 2000s (USD 6.5bnper year at end-2005/06 versus an average of USD 3bnbefore 1999/2000). This trend corresponds to gradualrelaxations of sector restrictions on FDI, which thegovernment makes in small doses. The majority ofcapital expenditure during the current cycle is largelyattributable to local enterprises that have become morecompetitive and able to rival other companies oninternational markets (see Table 3).

Bigger role in globalisation

Expansion of trade…

Stronger export performance …

The openness rate(13) of the Indian economy reached25% in 2005/06, compared with 8% in 1990/91. Theincrease has been particularly swift since the mid-1990s(see Chart 8, page 23). However, India still has a veryclosed economy – more so than its Asian neighbours –with tariff barriers that remain high. Export growth is

primary attributable to the strength of services exportssince the mid-1990s (up from 1.7% of GDP in 1990/91to 6.6% in 2005/06) but since the beginning of thisdecade it has also benefited from the surge in goodsexports, particularly from the manufacturing sector (73%of total goods exports), although services exports(particularly IT services and business processoutsourcing) continue to enjoy a stronger trend (seeChart 9, page 23).

A recent IMF study (2006) shows that the drop in thereal trade-weighted exchange rate is not solelyresponsible for the improvement in India’s globalcompetitiveness, as the survey includes periods ofdepreciation when exports were rising as well as periodsof depreciation when exports were slowing or evenfalling. An initial explanation for the performance ofexports lies with product diversification, and the


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Important names in Indian industry: globally competitive,globally recognised Hero Honda World No.1 motorcycle constructor Moser Baer World No.3 in digital media (CD, DVD, etc.) Hero Cycles World No.1 bicycle constructor Bharat Forge Among the world's three leading forge

manufacturers UB Group World No.2 alcoholic drinks maker Apollo Hospitals Largest chain of hospitals in South Asia Reliance industries World No.1 PTA* manufacturer Aravind Eye Hospital World's leading eye surgery hospital Mahindra &Mahindra Among the world's three leading tractor

constructors Telco Among the world's three leading truck constructors Welspun World No.1 in sponge-towels Gujrat Ambuja Among the world's five larges cement producers Table 3 Source: Confederation of Indian Industry (CII)(*) PTA: chemical compound used in the manufacture of textiles.

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development of specialisations in some segmentsenjoying the strongest growth in world demand. Forexample, exports of oil products, organic chemicals andelectric equipment, which accounts for a growingpercentage of Indian exports, have risen more quicklythan the international average. Secondly, there has beenan improvement in the non-price competitiveness ofmanufactured goods exporters (quality and image ofproducts, degree of innovation, shape-design, deliverytimes, sales advice, customer service) linked to theinternal restructuring carried out in industrial enterprisesin 1990, which enabled some of them to join the ranks ofthe world elite. Thirdly, Indian exports are moving moretowards strong-growth regions (main OPEC membersand emerging Asia) at the expense of the EuropeanUnion. China, Hong Kong and the United Arab Emirateshave recently become India’s most important customers.

…but there is still considerable potential

The room for Indian goods exports to grow further isconsiderable. These still account for just 8% of GDP (vs.30% in China) and 0.8% of world trade (vs. 6.4% forChina). As encouraging as they are, recent export trendsare not as impressive in India as in other Asian countries,which is surprising given the competitive labour costs andhigh productivity (see Table 4). Although wages in somesectors, such as services, have risen sharply (around 20%per year since 2000), the existence of a vast unorganised


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Monthly wages and earnings in the manufacturing industry (USD)1996 1997 1998 1999 2000 2001 2002

India 1/ 33.6 31.3 29.4 36.0 28.5 40.5 23.8 Philippines 1/ 260.0 247.1 189.1 213.5 Na 189.1 na Malaysia 1/ 443.2 430.1 na na 365.3 402.9 na China, PR 1/ 56.6 59.6 71.1 78.5 88.1 98.4 110.8 Hong Kong, RAS 3/ 1,334.8 1,463.6 1,512.1 1,527.9 1,523.5 1,555.8 1,532.4 Brazil 1/ 1,289.6 1,275.3 618.1 414.5 417.0 358.2 308.8 Mexico 1/ 182.8 206.5 228.8 250.2 307.8 360.5 366.4 Indonesia 2/ 77.0 72.0 25.6 38.3 46.5 50.4 na Thailand 3/ 217.1 189.2 154.5 156.2 na na na Table 4 Sources: IMF (2006a), International Labour Organisation

1/ Monthly wage 2/ Monthly earnings 3/ According to a Ministry of Agriculture survey

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sector and ample of labour supply are likely to havemaintained pressure on overall pay levels. As such, poorinfrastructures and the persistently high degree ofeconomic regulations are needed to explain India’s limitedpenetration of international markets. For example, the poorquality of the road and airport network creates longerdelays and higher transport costs than in other countries,not to mention the problem of electricity supplies or delayscaused by customs formalities.

Equally, import price barriers discourage exports.Despite falling significantly, from more than 40% in 1997to 14.5% in 2005 for the average non-farm tariff, averageimport taxes are still twice as high in India than in otherASEAN countries. As well as making imported inputsmore expensive, they force exported goods to be sold ata lower price than could be charged on the domesticmarket. For example, the IMF (2006) estimates that thecomplete removal of import taxes would raise the valueof exports by 45%. The case of the textile industryprovides a good example of these distortions. Whereas,since the abolition of international quotas in January2005, Chinese textile exports to the United States haverisen 200% and to Europe 80%, Indian textile exports tothe same destinations have climbed just 20%. Accordingto the WTO, India should have benefited greatly in termsof market share after the end of the quota system, buthas failed to take advantage as yet.

…and international financial ties

India’s participation in globalisation also involvestighter financial ties with the rest of the world. However,the method of external financialisation contrasts with thatseen during the rapid economic expansion of Asian NICsand the main ASEAN countries, which saw massiveforeign direct investment in export sectors. India’s role infinancial globalisation has so far been notable for thesubstantial import of volatile capital, with portfolioinvestments leading the way (+35% since 2003/04),attracted by rising corporate earnings on the back of abright medium-term outlook. The capital account surplusin the balance of payments tripled between March 2004and December 2005 (from USD 6bn to USD 18.6bn per year).

Although growing slowly, net FDI inflows remainlimited to under 1% of GDP (USD 6.5bn a year inDecember 2005) and mostly target sectors thatconcentrate on the local market. Active lobbying by theprivate sector – a traditional player of the Indianeconomy, dominated by groups formed prior toindependence – for the protection of its naturalmarket(14) and the fact that India’s development has sofar been concentrated in the tertiary sector, which usesless capital, are the two main reasons for the weaknessof FDI. Given the deregulation reforms, FDI istheoretically welcome in any sector, although there are caps (see Table 5). In the long term, furtherliberalisation and the development of an exportingindustrial sector will should lead to higher growth in FDI flows.

India’s financial integration is also the result of asharper rise in Indian businesses’ direct investmentabroad. This has reached around USD 2bn per annum,compared with less than USD 500m in 2000/01, mostlytargeting smaller countries on the subcontinent to takeadvantage of lower production costs(15) (see Chart 10,page 25).

Short-to-medium term: financial riskslinked to strong growth

With Indian growth standing above trend (highproduction capacity utilisation rate), the rapid rise innon-food credit has created a risk to the quality of


Sector restrictions on foreign direct investment � FDI is virtually welcome in almost all sectors � Current limits per sector:Defence up to 26%Civil aviation up to 49%Insurance up to 49%Telecoms up to 74%Construction up to 100%Retail sales up to 51% for single-brand store Urban development up to 100%� To come: banking sector in 2009

(currently 5%) Table 5 Source: Confederation of Indian Industry (CII)

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banking assets and generated tension on domesticliquidity. Furthermore, inflation within the economy(measured imperfectly by wholesale prices) remainscontained but stock market and property prices areclimbing. Also, India is becoming more vulnerable to theoutside world as imports are widening the currentaccount deficit, which is mostly financed with short-term capital.

To preserve growth and avoid repeating themistake of 1995/96 when it raised interest rates toosharply, the Reserve Bank of India – the central bank– started tightening its monetary policy gradually inOctober 2004 (+100bp in total). The latest increase inJanuary 2006 brought the reverse repo rate to 5.5%.The RBI is also tightening monetary conditions in aqualitative way by introducing toughening prudentialnorms (increasing the weighting of risky assets –(commercial and residential property, personal loansand credit cards) – in the capital adequacy ratio)).Other counter-cyclical measures include raising therate of provisions on these same asset lines. However,credit is showing no sign of flagging as yet. After atemporary slowdown from 38% to 31% y/y betweenSeptember and November 2005, it reacceleratedslightly in January 2006. Commercial credit isstructured into three main categories: credit to prioritysectors (farming and small-scale industry) for 37% ofthe total, credit to medium- and large-sizedbusinesses (31%) and credit to individuals (23%). It isthe last category that has grown in weight most overthe last few years.

Banking system: credit and asset quality

As is the case in many Asian countries, Indian bankshave developed retail banking and mortgages in recentyears, while corporate credit has stagnated. Thisdevelopment comes on the back of the difficultiesencountered by the industrial sector in the 1990s andsubsequent restructuring, as well as the central bank’sdecision in 2000/01 to reduce the risk weighting onfinancing residential property from 100% to 50%.Growth in the middle classes, which increases solventdemand, the increase in the working population, the

structural decrease in domestic interest rates – helpedby stiffer competition between banks and creditinstitutionsxvi(16) – and tax incentives to buy homes,ultimately created an attractive business climate forbanks to develop an extensive range of consumer credit(personal loans, vehicle financing, credit cards,mortgages). Meanwhile, there was a disintermediationtrend in financing for Indian enterprises who lookedmore towards local capital markets (international forlarge groups) on which the global liquidity effect has ledto a significant drop in cost of borrowing over recentyears.

At the end of March 2005, all products combined,household credit accounted for 24% of outstandingcommercial bank loans, compared with 11% in1999/00, representing an average annual growth rateof 35%. Mortgages grew the fastest (12% of thehousehold credit portfolio, versus 7% for consumerloans). The number of credit cards reached 15 millionin March 2005 with outstanding accounting for around1% of the portfolio total. The risk to asset quality didnot materialise – non-performing loans linked to retailbanking account for a marginal proportion of the total– but it is still present and is likely to grow over thecoming years given the current growth rates, andbecause Indian banks are too inexperienced on thissegment to have developed an ad hoc riskmanagement infrastructure. However, the room forIndia to catch up on its household credit (10% ofGDP) is significant compared with other Asiancountries.


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Tension on domestic liquidity

Although the quality of credit has not deterioratedsuffered yet, credit growth is posing a more tangible riskto domestic liquidity (see Chart 11). The liquidity ratio incommercial banks (deposits to credits) was stillcomfortable at 150% in February 2006, but it hasplummeted since its high of 230% in June 2001 at thestart of the credit boom. At this rate, surplus liquidity inthe banking system will have disappeared by 2008/09.As it is, tension on domestic liquidity has beengerminating for at least a decade if we consider thegeneral acceleration in commercial credit to the privatesector and the slower rate of bank deposits. Thesepressures have intensified with the slower accumulationof official currency reserves in the past two years due tothe reappearance of a current account deficit. Inaddition, lower interest rates and the stock market rallyhave encouraged households to reallocate theirdeposits in favour of higher-yielding financialinvestments with non-banking financial institutions(mutual funds in particular).

Indirectly, this tension plays into the central bank’shands(17) by avoiding the need for it to raise its keyinterest rates straight out. By leaving short-term interestrates to rise above the range formed by the interest rateat which the RBI soaks up liquidity into the bankingsystem (reverse repo rate of 5.5%) and that at which itinjects liquidity (repo rate of 6.5%), banks are forced toraise their prime lending rates. It remains to be seen forhow long this tightening by stealth can replace a policyrate hike, which has a more direct influence on creditsupply. To help banks attract more deposits, the centralbank recently raised interest rates on non-residents’deposits, although these are less important to domesticliquidity than 15 years ago. Between 1990/91 and2004/05, outstanding thereon fell from 13% to 8% of totalbank deposits.

Is the stock market overvalued?

The main Sensex index on the Mumbai marketplacehas gained around 280% since late 2002/03.Meanwhile, stock market capitalisation has risen from

30% to 90% of GDP. From 2002/03 to 2004/05, theincrease in prices reflected earnings growth, numerousIPOs, and M&A activity in all sectors – traditional suchas cement and steel, or in the new economy – whileprice/earnings ratios varied little (around 15x). The stockmarket boom continued in 2005/06 but P/E ratios leaptto 20x in the space of a few months (see Chart 12),raising the question of how accurately businessperformances are being reflected. The increase is atleast partly due to a catch-up effect after the mediocreperformances of previous years. However, the vitality ofthe equity markets also illustrates the reality of thediversity and new-found strength of the productivesector, which offers a broad range of investmentopportunities for residents and non-residents. Thesector leaders belong to the new economy – especiallyoutsourcing – and the biotech (pharmaceuticals) sector,


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which boast higher valuations. These are industrialsectors focusing on exports (textile, spare vehicle parts)and the domestic market (infrastructure, residentialconstruction). A third of the Indian economy shouldbenefit from higher international manufactured goodsand commodity prices (oil, iron ore, ferrous and non-ferrous metals, precious metals, farm produce, sugar,cement). Other sectors such as retail trade, the pressand advertising are drawing strength from consumerism.All in all, there is no clear answer to whether aspeculative bubble has emerged.

Which is the weight of portfolio investments on theIndian stock market?

The Mumbai stock market has risen considerably onthe back of massive equity portfolio investment. Thatsaid, in March 2006, this accounted for just 15% ofmarket capitalisation versus 11% a year earlier, easingfears of a possible inversion of flows in the event of areturn of risk aversion. Furthermore, the typicalinternational investor on emerging markets haschanged since the Asian crisis of 1997. Now it is mainlypension funds seeking long-term investments onmarkets with strong potential. Among these, Indiapresents the added bonus of having a stableinstitutional and democratic environment. Residentscontinue to dominate the local market with anincreasing number of households (tax breaks, betterchoice of savings products) at a time when equities arestill underrepresented in Indian investment fundportfolios (less than 5%).

External vulnerability has increased but is under control

Strong domestic demand and high oil prices on theone hand, and financial globalisation on the other, havedeeply affected the balance of payments profile.Although this continues to register annual surpluses, theaccumulation of currency reserves has slowed due to awider trade deficit at a time when fungibility hasincreased with the influx of “unstable” capital (see Chart 13).

The chronic trade deficit suddenly widened after2004/05, reaching around USD 52bn per year (6% ofGDP) due to the significant rise in the energy bill (+32%y/y in December 2005 to USD 36bn a year), making oilthe country’s number one import. Non-oil imports havegrown more rapidly (+45% to USD 114bn a year), drivenby capital and intermediate goods. A trade deficit on thisscale is not viewed as a threat as long as the currentaccount deficit (USD 13bn a year, 2.5% of GDP)remains limited due to the substantial balance of servicessurplus and as long as it can be financed with capitalinflows. Eventually it will pose a problem, though, asIndia’s energy dependency is set to increase further (thecountry currently imports 70% of its oil needs) (see Chart 14).


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Financing of the current account deficit is more thancovered by the capital account but the situation hasbecome somewhat more problematic in recent years.The leap in the balance of capital surplus (USD 27bn ayear in December 2005, 3.5% of GDP) is above all dueto a mass influx of volatile capital (portfolio investments)or money that can be easily withdrawn: commercialdebt, especially external commercial borrowings (ECBs)– mainly in the form of foreign-currency convertiblebonds (FCCBs) issued by listed companies(18) – andshort-term loans. Over the first nine months of 2005/06,these flows amounted to USD 13bn, USD 11bn andUSD 2.5bn respectively, up 35%, 62% and 25% y/y(see Chart 15). At USD 137bn in February 2006, thestock of official foreign currency reserves isconsiderable, corresponding to a little over a year’scoverage of goods and services imports (see Chart 16)– but it is not much as higher than the amount of “hotmoney” (sum of portfolio investments and short-termdebt) in the economy, which was estimated at USD102bn in 2005/06.

Overall, there is a risk of covering the balance ofpayments deficit, which remains dependent oninternational investors’ risk appetite. Nevertheless, thedominance of volatile or easily retractable capital is away for foreign investors to take up position in India, ata time when direct investment is still relativelyunattractive. Not only does the business climate remainaffected by poor quality basic infrastructures and heavybureaucracy but sector restrictions remain significant.With further likely relaxations in this area, capital flowsinto India will eventually balance out in favour of morestable financing.

Against this financial backdrop, the Indian authoritiesare opening the capital account cautiously. Although therupee has been convertible in trade transactions since1994, the government is still reluctant for this to happenwith financial transactions, especially given the Asiancrisis of 1997. There are numerous restrictions in bothdirections and the process of liberalisation is beingundertaken step by step, often with utilitarian goals(19).Other prerequisites to a complete opening of the capitalaccount have not yet been met. Firstly, the situation forpublic finances remains bleak despite the start of aconsolidation, and this discourages foreigners from

holding government bonds. Secondly, the bankingsystem is underdeveloped in terms of total assets giventhe economy’s borrowing requirements(20) – even ifsome banks have begun capital increases, particularlyin light of the Basel II reform – and it will remain heavilyprotected from foreign competition until 2009. Lastly,the economy is still not sufficiently deregulated and itcould be destabilised by a massive inflow of foreigncapital.

Adaptation to the “Indian way” will benecessary in the long term

Alongside the financial risks attached to strongereconomic growth, other more worrying trends linked topoor employment growth have been confirmed since the


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1990s. The growth model of the 1950s-1980s (see Insert 3) had encouraged an increase in job creation,even if most positions were in the vast, unorganisedsector. In the 1990s, not only did the elasticity ofemployment to growth in the organised sector becomealmost nil(21) but employment growth in the unorganisedsector waned. As such, reforms have changed therelationship between economic growth and employmentin the unorganised and organised sectors.

The unorganised sector (92% of the total workforce)has stopped creating jobs. Whereas, at the beginning ofthe 1980s, farming (an essentially unorganised sector)still accounted for a significant proportion of GDP (40%)and employment (70%), the limitations of the Green

Revolution led to an overall slowdown in agriculturalproduction growth from 3% in the 1980s to 1% over thefollowing decade, with a stagnation in employment. Thedecline in the relative weight of primary sectoremployment in the total was due to farm workersswitching to subsistence jobs in the unorganised servicessector.

From the second half of the 1980s, weak growth inpublic and private industry led to a decline in employmentin the organised sector: job losses in the public sectordue to disinvestment coincided with redundancies in theprivate sector, owing to restructuring arising from theshock of opening up to foreign trade. In the organisedindustrial sector, the rise in private employment was not


Insert 3: characteristics of the Indian growth model from the 1950s to 1980s

It is difficult to compare the Indian growth model to the experience of other Asian countries, even China. It is based on self-generated growth reliant on a vast public sector, which transferred extreme state control to a private sector that was alreadyrelatively strong at the time of independence. Put simply, the various aspects of this model, which was based on the economicpolicy choices made up to the beginning of the 1980s, are the following:

� Import substitution: - reduce dependence on imports by introducing strict trade constraints;- create public monopolies in infrastructure industries (*);- prevent foreign direct investment.

� Channelling of available resources into industrial sectors designated as priority, some of which will be reserved for thepublic sector; existence of public-private partnerships – with the limited participation of the private sector – due to a low domesticsavings rate.

� Existence of a vast private sector, unlike many emerging countries, even if it is subject to a system of strict administrativeregulations (prior authorisation system, or Licence Raj) – favouring corruption – for investment, the import of capital andintermediate goods, access to foreign exchange markets, control of bank loan allocations and prices, as much to control theconcentration of economic power (limit on the size of large enterprises and industrial groups) as to save capital for the publicsector. Constant threat of nationalisations (case for banks in 1969).

� Restrictive laws governing employment protection, especially for large enterprises. In 1976, it became compulsory for acompany with 300 employees or more to obtain permission to make redundancies. In 1982, the threshold was lowered from300 to 100.

� Reservation policy for small-scale industry (Insert 1). But in the absence of earnings objectives or foreign competition,this policy of reserving entire segments of industrial production created an under-optimal rente economy, leading to the emergenceof groups opposed to liberalisation and openness.

Sources: Boillot (2006), IMF (2006b).

(*) Virtually inexistent on independence, the industrial public sector controlled up to 25% of value-added but it is veryconcentrated (less than 5% of business but accounting for more than 30% of capital).

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enough to offset the fall in public employment. And dueto the partial dismantling of the reservation policy, thepersistence of a dual formal/informal labour market – caused by job security laws – prompted industrialenterprises in the organised sector to specialise in moreactivities that were either more capital intensive (havinga greater weight in total industrial value-added) or moreproductive (availability of qualified labour).Small-scaleindustry in sectors that were still protected, accountingfor a large number of jobs in the unorganised sector,became subcontractors(22).

These considerations help to explain the extent towhich the change in the breakdown of employment failedto mirror adjustments in the structure of GDP. Therelative reduction in the weight of farming in value-added(from 58% to 24% of GDP between 1950 and 2000)almost exclusively benefited services (from 28% to 49%

of GDP), with the weight of industry stagnating at 27% ofGDP in the 1990s (around 20% for the manufacturingindustry). Farming still accounts for around 60% of theworkforce and more than 800 million rural inhabitantslive in precarious conditions, while the percentage ofemployment has risen only slightly in services (26%) dueto productivity gains(23) and in industry (18%) (see Tables6 and 7). The latter remains dominated by the informalsector with a break-up of the network of enterprisesincluded in the small industrysmall-scale industryreservation policy, while employment in the formal sectorhas been restricted due to employment laws targetinglarge businesses.

Despite the original intentions, the change in thestructure of the economy and employment has thereforenot given rise to a labour-intensive industry in theorganised sector, not even absorbing growth in the


Employment by sectorMillions %

1983 1993 1999 1983 1993 1999 Farming 151 191 191 63 60 57 Industry and building 37 50 59 16 16 18

Manufacturing industry 28 35 41 12 11 12 Construction 7 11 15 3 3 4

Services 51 75 87 21 24 26 Shops, hotels, restaurants 18 27 38 8 9 11 Transport and communications 7 10 14 3 3 4 Finance 2 3 5 1 1 1 Social and personal services 24 35 31 10 11 9

Total 240 316 337 100 100 100 o/w non-farm 88 125 146 37 40 43

Table 7 Source: Planning Commission 2002, in Boillot (2006)

Breakdown of GDP and employment by general sectorGDP Employment

Primary Secondary Tertiary Primary Secondary Tertiary1950 100 58 14 28 72 11 17 1960 100 53 18 29 72 12 16 1970 100 46 22 32 72 11 17 1980 100 40 24 37 69 14 18 1990 100 32 27 41 67 13 21 2000 100 24 27 49 57 18 26 2005e 100 24 27 49 52 19 28

Table 6 Sources: CSO and Economic Survey 2004-2005, Government of India, in Boillot (2006)

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working population. It would require nearly 10 millionnew jobs each year (abstraction made from emigration)to absorb young people’s arrival on the labour market.But the opening of the economy and industrialrestructuring have been weighing on job creation sincethe 1990s: around four million new positions have beencreated every year, compared with eight million in the1980s. As it is, the divergence between growth in theworking population and in employment heralds a majorsocial and economic problem.

Risk of a shortage of qualified labour

The expansion of a mass manufacturing sector is allthe more desirable as hi-tech sectors may have toconfront a shortage of qualified labour in the near future.Each year, India “produces” 2.5 million English-speakinguniversity graduates but only 350,000 of these areengineers heading for jobs in sectors of the neweconomy. Thanks to its prestigious technology andmanagement institutes, India may holds the largest poolof qualified labour among low-cost emerging countries.However, specialisation in certain technological nichesectors is such that only a quarter of these 350,000would be immediately operational; the remainder wouldrequire additional in-house training.

Given the circumstances, the qualified labour market inIndia is very tight, especially as many foreign businesseshave relocated to the country, increasing competition. Ajoint report from the National Association of Software andServices Companies and McKinsey Consultants (2005)forecasts a shortage of 500,000 professionals betweennow and 2010, and estimates the number of specialistengineers needed if Indian companies are to remain worldleaders in IT services (65% of the global market share) andoutsourcing (46%) at 2.3 million.

Can we be optimistic about India? Yes,but…

GDP growth should be hold up over the coming yearsbut there is no guarantee it will remain at its current ratein the long term unless there is a huge increase in publicinvestment in physical infrastructures. To do this, several

measures will be necessary: taxation that is better suitedto the economic structure, public/private partnerships,use of foreign debt.

Reforms: the biggest are yet to come

The future of reform is not in doubt, as a broadpolitical consensus has developed over time, recognisingthe benefits to the economy. However, the rate ofprogress will vary according to cultural, social andpolitical constraints.

In May 2006, Manmohan Singh’s government willhave been in power for two years. The UnitedProgressive Alliance, led by the dominant party incongress with the support of the Indian CommunistParty came to power after the surprise defeat of theprevious, predominantly Hindu and nationalist party.Allaying initial fears over the future of reform, thegovernment immediately pledged to continuederegulating the economy. Reforms carried out since2004 have involved the abolition of capital gains tax, areduction in the rate of corporation tax, a revision ofincome tax brackets, the introduction of a value-addedtax, a further reduction in import duties, the continuedliberalisation of foreign direct investment, and the revivalof the fiscal adjustment plan for 2005/06 that had beenput on hold the previous year.

However, the achievements could have been greatergiven the government team’s considerable ability, andbecause Mr Singh happens to be the architect of thereforms launched after the 1991 payments crisis. Theslowing of reform is mainly due to the need forcompromise in an eclectic coalition without which Indiawould slide back into a period of governmental instabilitythat would be even more damaging to the economy.However, strong growth also leads to complacency andinertia. The main reforms (see synopsis below) are yet tocome.

� Physical infrastructures (congestion of the roadnetwork, ports, airports and rail system; mediocre publicservices). These remain a major hurdle to stronger growththat is more sustainable in the medium term. Publicinvestment in infrastructures is negligible (2% of GDP)


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given what is needed. Hence the increasing use of public-private partnerships to ease pressure on the state budget(recent example being the work to modernise the Mumbaiand Delhi airports, which started in early 2006).

� Electricity sector. The main problem is chronicblackouts despite low consumption per capita.

� Labour laws. The recent presentation of aCongressional bill in parliament concerning social protectionfor employees in the informal sector should smooth theway for another bill to raise the threshold above whichcompanies must obtain permission to make redundanciesfrom 100 to 300 employees.

� Return of public disinvestment. Opposition from thecommunists has frozen disinvestment in India’s spearheadstate-owned companies(24), but sales of minority shares inother profitable public enterprises are still permitted. Theaim is to raise 50 billion rupees each year (USD 1bn).Foreign ownership of profitable private banks will remainlimited to 5% until 2009 (insurance companies 26%). Thegovernment’s minimum stake in state-owned banks remainsfixed at 51%.

� Modernisation of farming – subsidised but neglectedin two waves of reform, contributing to the rural exodus.

� Bureaucracy. According to the World Bank’s DoingBusiness survey, it takes 22 days to start a business inSouth Korea, 41 in China and 89 in India. Despite a morereliable legal system than in China, it is harder to ensurea contract is honoured in India.

The need to clean up public finances remains intact

We can expect a new wave of reform but this willpartly depend on the government’s commitment tofurther consolidate public finances, which remain the keyproblem for the economy despite strong nominal GDPgrowth. The central government and federated statesconsolidated budget deficit is structurally high at morethan 7% of GDP (see Chart 17). Fiscal pressure is low,and tax revenues represent just 16% of GDP. The VAT

introduced in April 2005 and the streamlining of incometax last year are significant advances. Deeperrestructuring will be needed to adapt the tax system tochanges in the structure of the economy. The farm andservice sectors have largely escaped tax. Taxation onservices represents just 0.3% of GDP even though thesector generates half of value-added. Furthermore,numerous exemptions and other tax shelters enablecompanies to avoid paying tax.

In 2005/06, the central government managed toreduce its budget deficit from 4.3% of GDP to 4.1% (thefifth consecutive year of improvement), largely due togrowth, which stimulated tax revenues, but also VATdespite higher spending on infrastructure bottlenecksand social programmes to tackle poverty (introduction ofthe National Rural Employment Guarantee(25)). 2006/07will be notable for the Fiscal Responsibility and Budget


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Management Act, suspended in 2005/06. The budgetdeficit is forecast at 3.8% of GDP, which should bereachable even without new reforms due to growth in taxrevenues.

For a further, lasting reduction in the budget deficit, areform on the spending side is still lacking. This wouldrestore a degree of leeway, which is currently negligible.At a central government level, 75% of revenues aredirectly allocated to unproductive spending (interestpayments, defence, subsidies) (see Chart 18, page 32).At the state level, this ratio is 44% (civil services wagesand pensions, interest owed to the central government).It is essential that states regain some room formanoeuvre given that the main potential sources offuture growth lie in their hands (energy, irrigation,education, transport, healthcare, etc.).

In March 2006, government debt was estimated at84% of GDP (67% for central government, 17% for localgovernment net of intergovernmental loans) (see Chart19 and Table 8). Secured debt, which is a contingentliability, stands at 3% for central government and 7% at astate level. Indian public debt is mostly fixed-rate, rupee-denominated and held by residents. Its trajectory is notexplosive, but the debt to GDP ratio continued to risesteadily over the 1990s despite stronger nominal growth.It stabilised only recently. Equally, it was the drop indomestic interest rates that reduced the interest burden,from 7.6% of GDP in 2002/03 to 6.5% in 2005/06.

With India and China, emerging Asia is currentlyhome to two major growth drivers. The recent spurt in therate of Indian GDP growth to around 8% is probably dueto the catch-up effect accelerating on the back of theindustrial sector. Emerging from a period of positiverestructuring, this sector must be able to meet increasedomestic, and in particular foreign demand. Theimprovement is above all structural as it has been madepossible by greater flexibility of the domestic market,

increased openness to the outside world and bettercompetition between businesses, from which theinvestment cycle draws all of its strength.

However, the perversity of some choices of economicpolicy between 1950 and 1980 introduced distortions intochanges in the economic structure and the specialisationof businesses, weighing on the concentration ofemployment in the unorganised sector. Subsequently,the response of industrial and service enterprises toreforms meant there would be no improvement inemployment trends. India stands out from otheremerging countries as the percentage of labour in thefarm sector is still high. This is due to the development ofa high-productivity tertiary sector and a narrow, counter-performing industrial sector, whether it be the reservationpolicy for small-scale enterprises or restrictiveemployment laws for larger firms. Unlike in China, these


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Combined Interest (RHS)

Central govt.: domestic debt

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States: net debt owed to central government

Public finances: consolidated debt of the general government (in trillions of rupees and as a % of GDP)

FY2002 FY2003 FY2004 FY2005 General government 21.1 23.8 26.9 29.7 % of GDP 85.5 86.1 86.5 84.3 Central government 17.0 18.7 21.2 23.7 % of GDP 68.8 67.9 68.3 67.3 - Domestic 15.0 16.9 19.3 21.7 - Foreign 2.0 1.8 1.9 2.0 Federated states 4.1 5.0 5.6 6.0 % of GDP 16.7 18.2 18.2 17.0 Table 8 Sources: IFI, Reserve Bank of India

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policies have failed to create a labour-intensiveorganised manufacturing industry. Businesses havetended to specialise in capital intensive sectors or nichetechnologies, which rely on qualified labour. India’simpressive technological capacity (nuclear, IT, space)partly results from a learning curve process arising fromimport substitution.

With the manufacturing sector still struggling in itsefforts to streamline in response to economic openness,industrial employment growth could remain weak overthe years ahead. The industrial structure will evolveslowly even if we assume the total abolition of reservedsectors and reduced employment protection. Will Indiaallow the risk of a social crisis to materialise due to thedifference between economic and employment growth?It is worth remembering that the two waves of reform inthe 1980s and 1990s followed crises: political in the firstinstance (and failure to reduce poverty), financial in thesecond (and failure of the self-sufficiency model).Sensing the threat, the government has placed theemphasis on subsidised social programmes in certainlabour-intensive sectors (tourism, public works withmodernisation of the motorway network in particular) butthis is not a long-term solution.

Irrespective of the employment element, GDP growthof 8% or more – fuelled by the new consumption modeland the productive investment cycle – only appearssustainable in the medium-term if at least some of theexisting or future bottlenecks are cleared, especially inmatters of physical infrastructure and qualified labour.Given the slow consolidation of public finances, whichinvolves adapting the tax system to India’s new economicstatus, plans to raise public investment will have to beextended to finding alternative long-term financing, suchas public-private partnerships or calls for foreigninvestment.

Drafting completed on 3 May 2006

[email protected]

BIBLIOGRAPHY ITEMS

CRISIL, June 2003: “Employment Patterns in the1990s”.

CRISIL, February 2006: “Employment in OrganisedManufacturing: Rising Concerns”.

Deutsche Bank, November 2004: “India’s ChangingHouseholds”.

Diana Hochraich (DGTPE), 2006: Economic Study ofIndia.

Financial Times, 26 January 2006, special study onIndia for the Davos economic forum.

FitchRatings, March 2006: “Managing growth – TheChallenge of Consumer Lending in Asia”.

IMF, January 2006: “India: Selected Issues –Assessing India’s External Competitiveness”.

IMF, January 2006: “India’s Pattern of Development:What Happened, What Follows”, K. Kochhar et al.Working Paper WP/06/22.

Jean-Joseph Boillot (2006): “L’économie de l’Inde”,Repères, La Découverte.

Joël Ruet (LSE, CERNA), November 2005: “Modèleindien de capitalisme”.

Nasscom and McKinsey (common study), December2005: “Extending India’s Leadership in the Global IT andBPO Industries”.

Senate report of India, June 1999 (J. Chaumont).


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NOTES

(1) With GDP growth estimated at between 7.5% and 8% for 2005/06, the average growth rate between 2003/04 and 2005/06is between 7.6% and 7.8%. For 2006/07, growth should at about 7%.(2) The reference in time is financial year N/N+1, which runs from 1 April N to 31 March N+1. (3) This average rate of 3.5% has been called the "Hindu rate of growth" in reference to the post-independence period of ahighly regulated and planned socialist system (1950-1980) when the Indian economy was capable of generating only weakgrowth.(4) Even with a decline in its relative importance to the economy, farming still accounts for 24% of GDP and continues to playa key role in the Indian economy due to the significant percentage of the working population that lives directly on income fromthis sector. (5) India is rated BB+ by Standard & Poors and Baa3 by Moody’s, on the dividing line between the speculative grade andinvestment grade categories, which separates high- and low-risk issuers. Among the BRIC (Brazil, Russia, India, China), Indiais the second lowest rated economy along with Brazil. China and Russia are both in investment grade.(6) IT services: information technology services.(7) BPO: business process outsourcing.(8) There are 2.5 million new higher education graduates emerging from universities and management and technologyinstitutes each year. Traditionally, India has attached considerable importance to higher education. In PPP dollars, India hasspent a lot more money per student than any other country in emerging Asia. In 2000, India spent the equivalent of 86% of itsGDP per capita on every higher education student, compared with 14% for every primary school pupil. In China, these figureswere just 11% and 12% respectively. Source: IMF (2006b).(9) Alongside M&A, demergers are becoming more frequent (Bajaj Auto, Sun Pharma, etc.) as, in some cases, they make iteasier to form joint ventures, which make technical collaborations and fund raising easier.(10) Base chemicals and non-oil and coal products.(11) The south-west monsoon is the most decisive, moving from the sea to land. It usually hits the western coast of India atthe beginning of June and sweeps through South Asia until September. Due to the critical importance of the rain that it bringsfor farm production, forecasts on the date of the monsoon's arrival are monitored closely by the public powers and farmers tocalculate the optimal date for sowing.(12) We can show the widening of inequalities by, for example, comparing the average per-capita income of Delhi residentswith that of the population of Bihar (the poorest Indian state). In 1994, the former was six times higher than the latter. In 2002it was eight times more. Source: Deutsche Bank (2004).(13) Openness rate: ratio of the average volume of exports and imports of goods and services to GDP.(14) International integration and Indian companies' increasing technological role have involved partnerships with othermultinational groups, who are seeking access to the Indian market by capitalising on their double rente: a rente of situationon their own multi-billion-dollar markets, and a monetary rente linked to strong organic growth, technological acquisitions(purchase of patents) and the financing of growth on other emerging markets via overseas acquisitions. Source: Ruet (2005).(15) Companies in industrialised countries are also becoming targets for Indian firms (the largest Indian acquisition abroad inthe IT sector was by a Bangalore SME, Subex Systems, which recently paid USD 140m for the British company AzurSolutions).(16) Newcomers are particularly aggressive on the consumer credit segment.(17) RBI monetary policy: explicit target of price stability and implicit objective of maintaining growth.(18) Foreign currency convertible bond issues involve a financial risk for Indian companies but these are subject to theprudential standards set by the regulatory authorities. These securities give investors the option of converting a corporatebond into shares in the same company before maturity, the conversion price being determined by the share price at the timeof the transaction, plus a premium. FCCBs are attractive when the stock markets are rising but generate debt in the event ofa sharp or lasting decline. However, in the absence of conversion (bear market), Indian companies should not find themselvesover-indebted, as they took advantage of restructuring in the late 1990s to reduce debt. According to a central bank study,gearing among a sample of non-financial private companies fell from 37% in 2001/02 to 26% in 2003/04. Source: “Financesof private limited companies: 2003/04", RBI Monthly Bulletin, January 2006 (article based on the annual audited accounts ofa selection of 1,365 companies, i.e. 10% of private non-financial companies, which ultimately shows that few Indiancompanies publish their results).

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(19) In 2004, to limit the appreciation of the rupee, access to currency was made easier for residents (raised limit for transfersabroad) and local investment funds, which – within certain limits – can buy shares in rated foreign companies. Two yearsearlier, all types of deposits by non-resident Indians were made convertible. However, residents still have no right to ownassets abroad, except for direct investment abroad. In contrast, foreign access to the Indian financial markets (equities anddebt, including government bonds) are still subject to strict regulations.(20) The Indian banking sector is still largely dominated by public banks, but it is profitable and suitably capitalised. The Cookeratio was 12.8% in 2005/06 but it was down for the first time since 2000/01 due to the increase in high-risk assets as apercentage of total capital, as well as the rise in the weighting attached to mortgages. However, the Tier-I capital ratio was8.5% and some banks have already increased their capital as they switch to the new Basel II standards.(21) Employment in the formal sector grew just 1% per annum between 1993/94 and 1999/00 (the last two dates of the five-year National Sample Survey), contrasting with real GDP growth of 6.5%. (22) The share of small-scale industry in value-added has fallen but its share (66% in 2001) remains higher than in largeenterprises.(23) Hi-tech sectors employ just one million people.(24) The nine “jewels” (Navaratna) of the Indian public industrial sector in which sales of government shares are frozen: BharatHeavy Electrical (67.7%), Bharat Petroleum Corp. (66.2%), Hindustan Petroleum Corp. (51%), Indian Oil Corp. (82%),National Thermal Power Corp. (89.5%), Oil and Natural Gas Corp. (74.1%), Steel Authority of India (85.8%), MahanagarTelephone Nigam (56.3%), Gas Authority of India (57.3%). (25) This plan guarantees 100 days of work per year (paying 60 rupees a day) to some 150 million rural households.

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