This is the second post in a 3-part series on development in India. Yesterday’s post dealt with challenges that India faces in modernizing its infrastructure. This post focuses more on India’s economy. In a recent article, James Lamont insists that government reforms must accompany improvements in infrastructure and education if India is to reach its full potential [“Potholes in the road,” Financial Times, 5 February 2010]. To underscore the impact that infrastructure improvements have had on the economy, Lamont begins his article talking about India’s steel industry:

“Staring out of his panoramic office window over New Delhi’s leafy Lodhi Gardens, S.K. Roongta has reason to be pleased. The mills and mines of the state-controlled company that he heads have just produced a doubling in net profits for the latest quarter and the industry veteran senses better times ahead. The optimism projected by the chairman of Steel Authority of India, known as Sail, is based on India’s powerful domestic market and a hunger for making things out of steel, such as bridges and electricity grids. Public spending on infrastructure and rising automotive sales have spurred domestic consumption of metals. In what is the world’s fastest growing large economy after China, industrial production as a whole has been running at double the rate of a year earlier. Steel demand grew 13 per cent last year.”

While China drives much of the global steel demand, domestic demand is driving profits in India — and that’s a good thing. Like China, the hopes of India’s economic future rests as much on increasing domestic demand as it does on fostering overseas markets. Lamont reports that increased domestic demand has helped India make it through the current recession:

“Sail is one of a number of India’s more inward-looking companies whose performance shows Asia’s third largest economy is one of the great escape artists of the global economic downturn. Hero Honda, the motorcycle manufacturer, Bharti Airtel, the largest mobile telephone network, and Marico, a maker of personal care products, have all sidestepped the downturn. Even information technology outsourcing, dependent on business from the US and Europe, appears to have emerged with a bigger global footprint than it had before. Macroeconomic policy has played an important part. India’s economy is taking a big gamble on growth. Rising inflation and the largest fiscal deficit for 20 years are being risked by the government of Manmohan Singh, prime minister, to power the economy to double-digit growth. The effort has won global applause. Robert Zoellick, World Bank president, says India has played ‘a helpful role’ in leading Asia’s recovery. India is now identified alongside China as one of a few poles of growth worldwide. But unlike China, it has an economy driven mainly by demand from its 1.2bn people rather than exports.”

Zoellick’s praise results from the fact that “India has emerged as a source of demand with higher spending on infrastructure, measures for its rural population and a growing middle class.” As I have repeatedly insisted, emerging market economies (as well as the larger global economy) depend on increasing the size of the global middle class. India is betting that its current economic course will help increase the size of its middle class and help bring millions of impoverished citizens out of poverty. Lamont continues:

“Much remains at stake. In spite of India’s rising status as a well-balanced economy with a strong internal motor, its destiny as an economic powerhouse is not assured. For durable growth, say economists, it has to show strong fiscal management and the will to narrow the gap between plans and implementation. With a large rural population, it also needs to raise agricultural output. Still, the word most commonly used to describe India’s economic performance over the past 18 months is resilience. Mr Singh, who also calls his country ‘a slow-moving elephant’, uses it frequently to describe 2009 growth in gross domestic product of 6.7 per cent and a bigger rise expected for this year. So does Pranab Mukherjee, his finance minister. The word has also caught on among foreign investors including Peter Löscher, chief executive of Siemens, whose attraction for a market ‘booming in terms of size and growth’ has prompted him to double the German engineering group’s investment there: Siemens is to design products specifically for Indian consumers.”

Although India has proven resilient, not all sectors of its economy have fared the same. Lamont reports that “export sectors such as diamond polishing, pharmaceuticals and textiles suffered sharp declines.” But, unlike China which remains dependent on exports, exports account for less than 20 per cent of India’s GDP.” More importantly, “foreign capital flows, which drained away at the end of 2008, have returned as confidence rises.” Lamont continues:

“The clock has been reset to where India was 18 months ago, when business leaders talked of growth to match that of China. A strategy combining high public spending, loose monetary policy and administrative reform is carrying the economy towards a potential double-digit percentage growth. According to Kaushik Basu, the government’s chief economic adviser, administrative reforms ‘along with the high savings and investment rate of 38 per cent will be sufficient to enable India to reach the 10 per cent growth rate mark within a few years’.”

India won its freedom from Britain in 1947. Given the fact that it probably took several years for the country to get weaned from British rule, one still must ask why it has taken so long for India to emerge as a potential economic powerhouse. As Lamont recalls, for decades India suffered from a “so-called ‘Hindu rate of growth’ of about 3 per cent.” He continues:

“The country’s ability to withstand the latest external shocks, albeit with a fiscal deficit of 6.8 per cent, has impressed. The reasons are threefold. First, domestic demand, primed by a fiscal stimulus directed at the rural economy, remained strong. The Congress party-led government preempted the downturn by introducing stimulus measures earlier in 2008 as part of its quasi-populist policies. These included pay rises for civil servants, and subsidies and job guarantees for the rural economy. Second, a heavy layer of financial regulation – frequently slated for hampering growth and globalization prospects – provided protection. The largely state-owned banking sector had been prevented from using exotic financial instruments. The temptation to keep these in place is strong. Third, the crisis was met with a confident policy response, in which the Reserve Bank supplied liquidity and the finance ministry provided a fiscal stimulus.”

Despite the fact that India’s economy has proven resilient during the current economic crisis, Lamont indicates that reform is still required in order to launch India’s economy to the next level. He reports:

“Economists and foreign investors argue that to sustain high growth rates, India requires a second wave of reform to follow financial overhauls accomplished by Mr Singh, when he was finance minister, in 1991. Then, he ushered out the ‘license Raj’ with its stifling tiers of bureaucratic permissions and regulations. Now, economists say, the country has to progress from low-cost and low-value service provision to higher value manufacturing and services. One priority is labor reform to help India overcome what Mr Acharya calls an ‘abysmally low’ number of good factory jobs.”

Those reforms are easier said than done. As I noted in yesterday’s post, some $98 billion in investments are on hold because the land required to build factories is being stubbornly held on to farmers who believe they aren’t getting a fair shake from the government and who also fear for their survival in a future in which they aren’t raising their own food. As a result, India has “reached a plateau of growth” from which the economy will only depart when it the country becomes more industrialized. Industrialization policy must be matched by “reforms in areas such as healthcare, education and poverty reduction.” In the midst of mostly good news, Lamont reports, “in other areas there is little momentum.” He explains:

“The liberalization of the pensions and insurance industries has stalled. The auction of third-generation spectrum for mobile telecommunications services has suffered repeated delays. Retuning the tax system has run into difficulties, while roadbuilding targets are seen as over-ambitious unless bigger incentives are provided.”

The Prime Minister, however, has a good track record and, according to Lamont, his top priorities include “education, health, infrastructure and agriculture.” He has a daunting challenge, since 300 million in India live on less than a dollar a day. Creating jobs for its impoverished population is critical if India’s economy is going to continue to expand and remain sustainable. In a country where working conditions have been harsh, the workforce is becoming more knowledgeable and expectant. Keeping India’s vast workforce content is not going to be easy. Already fatal labor confrontations are beginning to appear [“Deadly Labor Wars Hinder India’s Rise,” by Peter Wonacott, Wall Street Journal, 24 November 2009]. Wonacott, reporting from India, writes:

“This ancient city [of Coimbatore] has turned itself in recent years into a manufacturing dynamo emblematic of India’s economic rebirth. But a homicide case playing out in an auto-parts factory here is raising concerns about whether the Indian industrial miracle is hitting a wall of industrial unrest. Pricol Ltd., which makes instrument panels for the likes of Toyota Motor Corp. and General Motors Co., was rocked in late September [2009] when workers burst into the office of Roy George, its 46-year-old human-resources boss. Angry over a wage freeze, they carried iron rods, witnesses say, and left Mr. George in a pool of blood. Police arrested 50 union members in connection with his death, their lawyer says. Charges haven’t been filed.”

The murder of Mr. George is inexcusable and the perpetrators should be prosecuted. Inevitably, industrialization brings with it the rise of labor movements. Unfortunately, the George incident leads one to believe that Indian unions are utilizing the worst rather than the best practices of western labor unions. Violence and corruption have often been companions in labor relations — and both undermine trust and cooperation. Wonacott continues:

“Battle lines are being drawn in labor actions across India. Factory managers, amid the global economic downturn, want to pare labor costs and remove defiant workers. Unions are attempting to stop them, with slowdowns and strikes that have led at times to bloodshed. The disputes are fueled by the discontent of workers, many of whom say they haven’t partaken of the past decade’s prosperity. Their passions are being whipped up, companies say, by labor leaders who want to add members to their unions and win votes for left-leaning political parties. Adding to the tensions are the country’s decades-old labor codes, which workers and companies alike say require an overhaul. ‘We can’t be a capitalist country that has socialist labor laws,’ says Jayant Davar, president of the Automotive Component Manufacturers Association of India. The unrest serves as a reminder that India has far to go before it stands alongside the world’s other economic powerhouses.”

Companies need workers, but they can’t exploit them and expect them to remain passive forever. On the other hand, workers need jobs and their representatives can’t make unreasonable demands that price a company out of business — that’s a classic lose-lose scenario. Finding a balance in which labor and management work together in a congenial way has proven historically elusive. If India wants to move forward, it needs to find a path down which both labor and management can travel amiably. To date, that hasn’t happened. Wonacott reports that the current economic downturn, despite the fact that India has been more resilient than most nations, has exposed the battle lines between management and labor.

“[The recession] has pressed manufacturers to make some unpopular cutbacks — spurring labor actions that have slowed production further and suppressed growth. Strikes at India’s manufacturing and service companies rose 48% in 2008 from the year before, India’s Ministry of Labor says. This year, labor actions have hit manufacturers from Indian automaker Mahindra & Mahindra Ltd. to Finland’s Nokia Corp. and Swiss food giant Nestle SA. Workers at a unit of Korea’s Hyundai Motor Co. staged sit-ins in April and July, demanding recognition of an outside union and reinstatement of suspended workers. In September, workers at a unit of Japan’s Honda Motor Co. tried to prevent a trial of a new assembly line by threatening engineers and executives with shock-absorbers and motorcycle pieces, according to a court documents. Some confrontations have turned vicious. Last year, the chief executive of Graziano Trasmissioni India Pvt. Ltd., a manufacturing unit of Swiss high-tech group OC Oerlikon Corp., was beaten to death by workers who had been suspended at a plant outside New Delhi. The impact has been global. A strike that started in late September at Indian supplier Rico Auto Industries Ltd. left Ford Motor Co. without transmission parts, forcing it to halt production temporarily at an Ontario plant that makes Edge sport-utility vehicles and at a Chicago plant that builds Taurus sedans. The six-week Rico strike spurred GM to idle an SUV-production facility in Delta Township, Mich., for a week and cut one shift for a second week. GM also cut a shift at a transmission factory in Warren, Mich., said a person familiar with the matter.”

Wonacott goes on to detail the problems remaining at the factory where Mr. George was killed. The story isn’t pretty; but, I suspect, it will be a story repeated numerous times across India unless a better way forward is found. Both sides have a story to tell; but finger pointing never solves problems. The story of development always involves commercial interests (who create jobs), the government (that sets policies), and people (who do the work and buy products and services). When any one of those three sectors is suffering problems, development also suffers. Like a three-legged stool, it’s hard to keep the economy upright if a leg is missing or seriously out of balance. According to Financial Times‘ columnist Martin Wolf, India has done a fairly good job of remaining in balance during the current global recession [“India’s elephant charges on through the economic crisis,” 3 March 2010]. Wolf writes:

“Crisis? What crisis? Indian policymakers are not asking such a complacent question. But India has had a ‘good crisis’. Now its task is to unwind the exceptional support given to the economy and push through the reforms needed to sustain fast and inclusive growth. When Pranab Mukherjee, the finance minister, presented his budget last week he noted that a year ago, India confronted a double challenge: the global crisis, and a poor monsoon. Now, ‘I can say with confidence that we have weathered these crises well.’ … In the 2008-09 financial year, India’s gross domestic product expanded by 6.7 per cent. This year it is forecast to grow by 7.2 per cent. If the Indian economy has succeeded in surviving this test with so little damage, even cautious analysts must be more optimistic about the future.”

According to another Financial Times‘ article, India’s GDP could actually grow by 8.75 percent this year [“India shakes off gloom to forecast 8.8% growth,” James Lamont, 26 February 2010]. Even though Lamont’s article is generally update, he concludes: “Some economists have warned that India’s resilience to the global economic downturn should not lull policymakers into a sense that they need do nothing. They are urging the government to take steps to close a fiscal deficit running at 6.8 per cent of GDP and implement reform in the financial, health and education sectors and press ahead with infrastructure development.” Wolf also discusses the government’s fiscal deficit, and though he concludes that it is “quite sustainable” he also warns that “continuation of such deficits is undesirable.” He explains:

“First, much of the spending – particularly on fertilizer, food and petroleum subsidies – is poorly targeted. Second, the public sector’s savings collapsed from 5 per cent of GDP in 2007-08 to 1.4 per cent in 2008-09. This needs to be reversed. Before the crisis the country’s gross savings rate had hit 36 per cent of GDP.”

Wolf believes that India’s ability to attract long-term foreign investment means that India should be able to grow GDP by a sustained 10 percent — maybe more. During a recent trip to India, Wolf says that confidence among the country’s business elite “is palpable.” He concludes his article by discussing some of the things that India needs to do in order to turn confidence into achievement.

“Those in charge of a vast country with so many vulnerable people are rightly wary of making their economy hostage to the sociopathic tendencies of the financial sector. … Yet caution cannot be inertia. [Dr Shankar Acharya, a former chief economic adviser to the Indian government, drew up a list of reforms that need to be undertaken.] Acharya’s list of needed reforms rightly includes ‘infrastructure, agriculture, labor laws, banking, energy, education and retail trade’. Fortunately, a country as big as India could sustain fast growth even if the external environment remained less friendly than before. But that would make lifting internal obstacles to growth even more urgent. The external environment also matters, in at least three respects. First, India has followed China in becoming far more open to trade. … Second, India depends on access to foreign raw materials, particularly energy. So energy price shocks would be very destabilizing. Finally, India needs peace. India and China are both ancient civilizations. But China’s ancient state has a powerful legitimacy. India’s state is young. Politics are a permanent negotiation. Democracy is not, as some argue, an obstacle to India’s progress, but a necessary condition for its existence as a state. For all the frustrations and failures, the political system is workable.”

Wolf one day sees India assuming a permanent seat on Security Council of the United Nations. In fact, he recommends that the UK should “offer its seat on the security council of the United Nations to its former colony. Its condition would be that France does the same in favor of the European Union. Whether or not such enlightened statesmanship is forthcoming (presumably not), we are moving into the age of continental superpowers. Asia will be home to not one, but two, of them.” I’m not holding my breath on that one. Both the UK and France enjoy punching above their weight on the international stage. Nevertheless, India is on the cusp of becoming a recognized world power. It will actually achieve that recognition, however, only if it finds a way to turn its culture into a launching pad rather than an anchor.