India, Meet Icarus

Did you hear the good news? India’s economy grew at an (annualized) rate of 5.5 percent in the second quarter of 2012 (the last period for which data is available).

But wait: India averaged 8.1 percent growth from 2004 through 2011 — a period that included the global recession. What sort of Pollyanna is ready to give high marks for 5.5 percent?

This modest number did, in fact, beat growth in the first quarter of 2012. But the real story here is how rapidly expectations have evaporated that India’s day in the sun had finally arrived. With hindsight, it’s not difficult to explain the slowdown: Interest groups that have more to lose than gain from rapid growth have managed to reassert their veto power over dislocating economic reforms. And in India’s messy, corrupt (albeit democratic) political system, it is very difficult to take back the ground lost to defenders of the status quo.

Indian politics isn’t about to change. A big question, then, is whether India’s brand of governance is really compatible with a return of eight-percent-plus growth, or whether the world’s second largest country is going to have to make the journey to affluence one fumbling step at a time.

It’s easy to forget that India was the poster child of failed development strategy. From independence in 1947 to the late 1980s, it averaged just a shade more than two percent annual growth, barely enough to offset population growth. Pretty much everyone agreed long ago that the Indian economy had potential — fine elite education, a culture of enterprise, a wealthy diaspora eager to prove itself back home, and a common language that happened to be the language of international business. But it was horribly burdened by a venal bureaucracy, a hopelessly overtaxed infrastructure, and (worst of all) an ideology of self-reliance and central economic planning that had largely isolated Indian markets from global competition.

It’s also easy to forget that India’s economic breakthrough was virtually an accident: In 1991, facing a foreign exchange crisis created by currency mismanagement, the government appointed an apolitical technocrat, Manmohan Singh, as finance minister, with the goal of giving India a more credible façade for international lenders. Singh grabbed the mandate and ran with it, devaluing the rupee, cutting confiscatory tax rates, opening the door to import competition, and reducing regulation of large enterprises to a level closer to, say, Europe, than to Cuba.

The economy responded with such alacrity to newly unleashed market forces that pragmatic politicians saw a future in defending the reforms. And with GDP doubling in the first decade under Singh, and more than doubling in the second, the idea took hold that the Indian economic juggernaut was unstoppable. But it was never that simple, as recent growth rates clearly show; contrary forces were building. To understand why, consider a little perspective.

The great majority of Indians are much better off today than they were four (or fourteen) years ago. Gross Domestic Product per capita income, measured in terms of today’s purchasing power, has quadrupled between 1991 and 2011 to a respectable $3,600. What’s more, the distribution of income did not change radically. India’s GINI coefficient (a technical measure of inequality) hardly budged; neither did the percentage of India’s income going to the bottom-fifth of the population. But rapid change did make great wealth more conspicuous — especially in cities. According to Forbes, India has 55 billionaires (in U.S. dollars), most of whom do not hide their good fortune.

Moreover, income inequality between cities and the countryside has increased substantially. By no coincidence, one-third of all Indians (400 million people) who disproportionately reside in rural areas survive on less than $1.25 a day in terms of purchasing power.  

What’s more, Indians have little sense that the reformers are on the side of the poor. Big business was relieved of smothering regulation; yet for most of the population, daily life is still under the thumb of a corrupt, nitpicking bureaucracy that routinely sells services (education, welfare benefits, rule of law) that are supposed to be free.

Then there is the wretched state of India’s infrastructure. Everybody suffers from congested transportation, unreliable electricity, and hit-or-miss communications. But the poor (and, for that matter, the new urban middle class) suffer far more than big business and the wealthy, who have backup generators, private aircrafts, and dedicated telecom lines.

A few more words about corruption. India ranks 95^th on Transparency International’s Corruption Perceptions Index, behind such paragons of virtue as Liberia, Sri Lanka, and Jamaica. That hasn’t stopped businesses that can afford to grease the palms of politicians and senior bureaucrats from progressing; indeed, it helps them by raising the barrier to would-be competitors who don’t have the cash or the knowhow to spread the baksheesh.

But it is ferociously frustrating to everybody else: According to the World Bank, India ranks 182^nd (that’s right, 182^nd) on a list of 183 countries in terms of the difficulty of enforcing contracts. And the resulting pent-up fury has recently fueled a powerful populist reaction to the social displacement that is inevitable in a rapidly growing economy. As a result, pro-growth elements in the current ruling coalition (led by now Prime Minister Manmohan Singh) have been severely weakened.

Consider the issue of foreign investment in retailing. Singh wanted to allow foreign "big box" retailers like Walmart and Tesco to set up shop in India fuel the spectacular sorts of efficiency gains in consumer services that have swept through India’s business-service sectors — and to reduce the portion of crops that rot on the way to market. But the coalition required support from Mamata Banerjee, the chief minister of West Bengal who came to power defending farmers against attempts to take over their land in order to build an auto factory. Banerjee also proved to be an equally tenacious defender of shopkeepers as well as incumbent wholesalers who controlled the movement of fresh food from rural areas.

The rejection certainly jolted the perceptions of foreign businesses, which had begun to regard India as a must-invest economy, like China and Brazil. It wouldn’t be a make-it-or-break-it issue — if it didn’t reflect the larger reality that the country’s economic culture isn’t yet up to the challenge of supporting Asian-tiger rates of growth.

This is neatly illustrated in the confluence of factors that have limited the growth of manufacturing in India. Every East-Asian economic success story has been built around manufacturing exports. But, in spite of its vast supply of cheap, surplus labor and relatively strong management, only about 15 percent of Indian GDP is in manufacturing.

One of the most striking obstacles are the rigid labor laws created by independent India’s first governments. South Asia’s manufacturing juggernaut is fed by an endless, rapidly-churning supply of unskilled rural laborers seeking a better life in cities. But in India, once a worker is hired by a medium- or large-sized business, it’s almost impossible to fire him or her. So multinationals selling labor-intensive goods ranging from shoes to low-end consumer electronics are now gravitating to countries like Vietnam, where labor is malleable and where 40 percent of the GDP consists of manufactures.

Nor are labor laws the only obstacle. India, home to 1.2 billion in a land less than one-third the size of the United States, is a very crowded country; not surprisingly, siting a factory can be a legal and political ordeal. By World Bank tally, India ranks 181^st out of 183 countries in difficulty of obtaining a construction permit. (As alluded to above, Mamata Banerjee rose to power by stopping construction of a factory that was slated to build Tata Motors’ ultra-cheap, breakthrough car, the Nano.)

Even if one manages to find a place to build a big business facility, there’s the problem of supporting infrastructure. India’s roads, rail lines, and electric power and port facilities are all overtaxed. This factor alone can spell the difference in competitiveness in global markets that favor flexibility, speed, and just-in-time inventory policies.

And why, you might ask, is Indian infrastructure inferior to that of potential rivals? One factor is the legendary inefficiency of its state-owned enterprises, which serve political constituencies rather markets. Another is the inability to build new rail corridors through densely-populated regions, which channels low-cost rail traffic into high-cost truck traffic. Yet another factor is the failure to attract capital from foreigners who are wary of the uncertain legal climate — especially when it comes to big, high-profile projects that are catnip to corrupt politicians and bureaucrats.

All that said, the Indian economy is not about to fall off an economic cliff, or even return to the pre-1980s "Hindu rate of growth"– it still has much going for it. But these days, development specialists are more likely to cite economic institutions — regulation, rule of law, entrenchment of local interests —than logistics or education or natural resources in explaining why economies succeed or fail. And from this perspective, there’s no mystery why the Indian economy has downshifted. Indeed, the better question is, how has it managed to get this far?