The McKinsey Quarterly: A richer future for India

The McKinsey Quarterly: A richer future for India

This is a for-fee paper, here are a few excerpts.


A richer future for India
Two industries have shown what can be achieved when the country opens itself up to the world. Now the rest of the economy should follow suit.
Diana Farrell and Adil S. Zainulbhai
The McKinsey Quarterly, 2004 Special Edition: What global executives think
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The astonishing election upset in India has put the future of its economic-reform program in question. With the victorious Congress Party depending on Leftist parties for parliamentary support, uncertainty is running high about the future of the country’s privatization, deregulation, and foreign-investment reforms.
Voters have sent a clear message about the need for broad-based economic growth that lifts all boats. But some members of the winning coalition may well misinterpret that message. India’s recent experience—and that of its Asian neighbors—shows that continuing rural poverty stems not from too much economic reform but rather from too little. Since liberalization began, in 1991, annual GDP growth has been twice as high as it had been previously. As a result, poverty rates have fallen by nearly a third in both rural and urban areas. The celebrated software and outsourcing industries are only the latest evidence of the effectiveness of the reforms, which have created hundreds of thousands of high-paying jobs and generated billions in export revenues.
The challenge facing the new ruling coalition is to extend the success of the IT and outsourcing industries into the broader economy. To that end, foreign investment and global competition must be allowed to reach more sectors, including some in which the government now plays a significant role. Although India has broadly cut import duties and increased foreign-ownership limits over the past ten years, large parts of the economy remain sheltered by high tariffs and restrictions on foreign direct investment (Exhibit 1), which amounts to just 0.7 percent of India’s GDP, compared with 4.2 percent in China and 3.2 percent in Brazil. Imports total less than $70 billion—a small fraction of China’s $413 billion.
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And the answer is:
India has clearly benefited from closer integration into the global economy in industries such as automotive, business-process outsourcing, and IT. To build on that success, the government must now lower trade and foreign-investment barriers still further.
First, tariff levels should be cut to an average of 10 percent, matching those of India’s neighbors in the Association of South East Asian Nations (ASEAN). Although progress has been made on tariffs, the Indian government still prohibits imports of many goods and protects inefficient companies from foreign competition. To give those companies a chance to improve their operations, the government might first lower duties on capital goods and inputs. Then, over several years, it could reduce them on finished goods.
Foreign-ownership restrictions should be lifted throughout the economy as well, except in strategic areas, notably defense. At present, foreign ownership is not only prohibited altogether in industries such as agriculture, real estate, and retailing but also limited to minority stakes in many others, such as banking, insurance, and telecommunications.
India’s government should also reconsider the expensive but often ineffective incentives it offers foreign companies to attract foreign investment, for these resources would be put to better use improving the country’s roads, telecom infrastructure, power supply, and logistics. What’s more, MGI research found that the government often gives away substantial sums of money for investments that would have been made anyway.3 (To give one example, it has waived the 35 percent tax on corporate profits for foreign companies that move business-process operations to India, even though the country dominates the global industry.) Moreover, state governments often conduct unproductive bidding wars with one another and give away an assortment of tax holidays, import duty exemptions, and subsidized land and power. Yet MGI surveys show that foreign executives place relatively little value on these incentives and would rather see the government invest resources in the country’s poor infrastructure.
To attract foreign investment in labor-intensive industries, the government should consider making labor laws more flexible
Finally, interviews with foreign executives showed us that India’s labor laws deter foreign investment in some industries. It is no coincidence that software and business-outsourcing companies are exempt from many labor regulations, such as those regarding hours and overtime. Executives tell us that without these exemptions, it would be impossible to perform back-office operations in India. To attract foreign investment in labor-intensive industries, the government should therefore consider making labor laws more flexible.
Some Indian policy makers might argue that the reforms proposed here would undermine long-held social objectives, such as creating employment. But the evidence shows that regulations on foreign investment, foreign trade, and labor have actually slowed economic growth and lowered the standard of living. A decade ago, India’s per capita income was nearly the same as China’s; today, China’s is almost twice as high.
India’s economy has made real progress, but further liberalization will be needed to sustain its growth. The country now has 40 million people looking for work, and an additional 35 million will join the labor force over the next three years. Creating jobs for all these Indians will require more dynamic and competitive industries across the economy. Opening up to foreign competition, not hiding from it, is the answer