Indian Economy: Characteristics as developing economy

Indian Economy: Growth Story & Challenges

India is a lower middle-income country situated in South Asia. Over the last couple of decades, the country’s economy has performed extremely well, growing at more than 5 per event per annum since 1991. However, growth has slowed down recently. Here we take a look at India’s growth story and the problems its economy faces.

India became an independent country in 1947. It was a British colony for over 200 years. The colonial powers set up two types of colonies – extractive and settlement. India was an example of the former while countries such as America, Australia were examples of the latter.

The British didn’t as a consequence have any interest in developing India. It was used as a resource hub for industries in England. India would export raw materials to England and import finished items.

After independence, wary of foreigners, India became a closed economy. It had high trade tariffs and a heavily regulated economy. The period lasted until 1990 and it came to be known as the “License Raj”, as to carry out almost any economic activity, entrepreneurs needed the government’s permission. This stifled investment and productivity growth.

As a result, more than 30 percent of the population lived on less than a dollar day. In 1990, the country had to approach the IMF for a bail-out when it found itself in a balance-of-payment crisis. The IMF helped the country and asked it to reform its economy.

Under the stewardship of the then finance minister, Manmohan Singh, India opened its economy. This entailed depreciation of the Indian currency, i.e. the “rupee”, reduction of trade barriers among other reforms which were extremely successful and the country experienced high growth.

Today India is a major player in the information and technology (IT) sector. It is hard to imagine such success of the Indian IT industry if India had remained a closed economy. It exports a number of high value goods.

Rodrik, Hausmann, and Hwang (2005) found that the country exports goods that countries with much higher gross domestic products do. They reckoned that this was one of the reasons why the country has been able to grow so fast in the last couple of decades.

The growth also fueled a rise in the number of super-rich in the country. India is today home to some of the richest people in the world and has the fifth largest economy.

Its growth has enabled rescuing millions of people from extreme poverty. It was one of the first countries to achieve the MDG (Millennium Development Goals) of halving extreme poverty set at the beginning of the millennium. It achieved the goal in 2011.

A significant proportion of the population continues to suffer as a result of poverty. More than 20 percent of the population lives under the UN defined poverty line of 1.95 dollars.

In terms of growth however, India is a story only less impressive than China. Per Capita Income remains low at 2000 USD. In PPP terms it is around 5000 USD. Education levels remain abysmal. In the HDI Index, which broadly measures education attainment, income, and life expectancy, India is ranked poorly. It has a reasonable improved life expectancy of 70 years, but on education and income parameters, it performs poorly.

One of the major economic problems India faces, is unemployment. The country has 1.3 billion people and is poised to overtake China as the most populous country on the planet.

It can reap the benefits of the demographic dividend provided there is an overall improvement across parameters in HDI, Competitive Index of the World Economic Forum, Economic Freedom Index, MPI, and the other defining indexes. The lack of admirable state of the education system and Huge levels of unemployment, however, pose challenges in the country’s ability to take full advantage of its demographic situation. Jobs are not being created at the expected rate which is unfortunate.

The decision that had a colossal impact on the economy was that to demonetize 500 and 1000 rupee notes in 2016. It was done to weed out corruption and the resulting black money from the economy though. The swiftness of the initiative led to a liquidity crunch and a hit on the investor sentiment. In 2016, the Indian economy grew at over 7 percent, but as the effects of the demonetization started being felt, growth started slowing down and slipped to 6 percent.

The government has taken initiatives to overcome the liquidity crunch. It has reduced corporate tax rates and has tried to get citizens started using banks. However, the government’s reluctance to reform foreign direct investment in multiple key sectors of the economy continue to hamper growth and fuel uncertainty.

Inflation is another problem facing the country. Inflation in the country since its growth story began, has stood at 7 percent per annum. Part of it is fuelled by its defendency on imported oil and its love for gold. The country does not huge reserves of these commodities. As a result, it is compelled to import them. This leads to the country having unfavorable balance of payment which leads to depreciation of its currency.

India despite possessing large amounts of labor like China, has not been able to emerge as a manufacturing hub because of infrastructural issues and archaic labor law. It 2014, it was ranked 150 on the “Ease of Doing Business” index.

It’s labor laws make it extremely difficult firms to hire and pay off workers. Also as the number of workers increase, administration costs for the companies increase, preventing them from getting large. This problem can be said to be one of the main reasons why the country despite having advantages similar to China, has not been able to replicate China’s growth. Its labor laws could only be said to be the reason why the country has such a massive informal economy.

To get around regulations and administrative costs, individuals and firms operate in the informal sector. This also leads to loss of tax revenue for the government.

The government has taken steps but they are not enough. The BJP government came into 2014, promising widespread reforms and unprecedented job generation for the large and increasing labor force. The government has introduced a few reforms until now.

The tax system has been reformed with the introduction of Gross Sales Tax. Earlier trading between states for companies was cumbersome as different states had different tax rates. The government is contemplating reforming labor laws, but because of the political implications of it, it has been slow to take significant action. The government’s reform agenda has also in recent times been derailed by its social and political agendas. Its decision to provide fast track citizenship to refugees from neighboring countries of all faith but Muslims enraged its Muslim minority and led to mass protests across the country, diverting governments’ attention in the process.

In 2019, economic growth slowed down to 6 percent – the slowest in a long time. The government reduced taxes to boost consumption. However, that has not had any palatable impact on the economy.

The government has been slow to address the liquidity crunch resulting from the demonetarization exercise. Investment levels are not at desirable levels. The government needs to take steps to business investment. Due to low investor sentiment, the governments Made in India program is finding it hard to take off.

Rodrik finds that it is easy to achieve for developing countries to achieve economic growth through manufacturing. Neoclassical economic theory assumes that developing countries would converge with the developed ones. Ricardo comes up with two types of convergence – conditional and unconditional. Manufacturing enables unconditional convergence as the productivity in manufacturing approaches the global productivity frontier irrespective of the socio-economic environment in the country. As the country becomes good at manufacturing, it starts exporting leading to welfare gains, more favorable current account balance leading to access to greater foreign savings at competitive rates. This helps fuel investment and creates a virtuous cycle. In the case of India, this has not happened until now as the country has not been able to create the environment for manufacturing activity to take place as found earlier. It has a current account deficit, and a less than desirable credit rating. Investment could be fuelled by lowering interest rates but because of high inflation, the central bank does not have much room for action.

In January of this year, coronavirus started spreading in China, and now it has made its way to almost all the countries in the world. As a result of the virus, the Chinese government imposed strict restrictions on the movement of people. Economic activity in China had come to a standstill, leading to disruptions in global supply chains.

Many industries in India depend on raw materials from China though it is slowly consolidating its poise. The disruption is likely to subdue growth in the country further in the short run. If the Coronavirus menace goes into a large community spread in the country, it is estimated that thousands of people can contract it in a short period of time as the country has a high population density, inconsistent practices, inherent poverty and dismal lifestyle. To add salt to injury, there is a health infra that leaves much to be desired. Like China, this may result in the contraction of the economy rendering hundreds of thousands jobless.

Government’s efforts to privatize some of the large state enterprises have too not borne many fruits. In 2019, the government raised through sale of stakes in state enterprises.

Government’s efforts to deal with the economic crisis has been disappointing. The slowdown started more than a year ago and the signs had started to emerge many years ago. Investments were falling. Banks were crippling. The government ignored these signs and pursued policies such as demonization which reduced liquidity and create an environment of fear, causing investment levels to fall further. As the slowdown started reflecting in the GDP number last year, the government chose to deny the existence of a slow down and ignored the economy to pursue its political agenda. The few steps that it took didn’t address the biggest constraint on the economy.

Haussmann says that given limited resources and political capacity for reforms, to achieve maximum economic growth, the biggest constraint on the economy must be recognized and the appropriate policy that would fix it be adopted. Governments’ efforts thus seem to be all over the and not concentrated fully on addressing the elephant in the house. The government needs to reform labor laws in the medium run.

Rodri says that because of labor laws in many countries have a large informal sector which consists of many small inefficient firms and they cannot grow as they don’t have access to resources since they operate in the shadow economy. In the short run, it needs to stimulate demand through increased government spending and create an environment of trust in the economic sphere. Governments decision to reduce corporate taxes is unlikely to help as the economy suffers from a lack of demand due to liquidity crunch and joblessness.

Whereas the country did extremely well in achieving the MDG of halving extreme poverty, it found it difficult to achieve the other goals. Malnutrition at the end of 2015 was and is still today a major concern. According to UNICEF (2020), 43 percent of the children under the age of five and underweight. Malnutrition is responsible for 69 percent of the deaths of children under the age of 5.

At the end of 2015, approximately 50 percent of the population didn’t have access to toilets. The present government of Narendra Modi which came to power in 2014 encouraged the construction of toilets and today more than 90 percent have access to toilets. However, usage and maintenance of these toilets remain a problem as people are not used to using them. Bad sanitation leads to the spread of diseases which in turn makes individuals less productive.

There exists a significant amount of gender inequality as well. The male bias is reflected in the deteriorating sex ratio. In 2011 the sex ratio stood at 909 girls per 1000 boys. By 2019, it decreased to 877 girls per 1000 boys. The government banned per natal sex determination in 1994. Enforcement of the law has however not been robust and female fetuses continue to be aborted, especially in northern states. Male children also tend be more nourished and more likely to attain more education than their female counterparts. Discrimination on the basis of gender reduces labor force participation and takes away from several individuals their ability to lead a life full of opportunities.

The macroeconomic fundamentals have been suffering lately. The country escaped the 2008 financial crisis relatively unscathed as it had sound fundamentals. Large scale corruption by the Congress government of Manmohan Singh between 2009 and 2014, and then the subsequent neglect of the economy under Narendra Modi have wreaked the core of the Indian economy. Savings and investment levels as a percentage of GDP have fallen from 34.2 and 39.5 in 2010 to 29 and 31.5 in 2018 respectively. Investment is necessary for growth as it leads to productivity gains. At a time when the nations labor force is growing as it reaps a demographic dividend, lack of investment causes unemployment levels to increase and prevents the country from making full economic use of the favorable demographic situation it finds itself in.

The central bank in India, called the Reserve Bank India, began operations in 1935. After independence, it was nationalized in 1949 and became responsible for regulating banking in the country. Its Governor is appointed by the government and the constitution gives the government the right to interfere in the banks’ operations.

Over the years, notable economists such as Raghuram Rajan, Urjit Patel have served as governors. Raghuram Rajan served as the chief economist at the International Monetary Fund between 2003 and 2006. However due to lack of independence, they found it difficult to do the best for the nation.

The government’s desire to control interest rates to manage spending so that it does not have to take politically challenging decisions, such as reforming labor laws, has made the job of the RBI difficult. RBI’s control over monetary policy was utter weakened through the creation of the Monetary Policy Committee in 2016.

The RBI has an inflation target range of 2-6 percent. As with the business cycle, inflation in the country fluctuated, RBI changed the interest rates to keep inflation and spending at optimum levels. Between 2001 and 2005, inflation remained within the target range. In response, RBI decreased interest rates throughout the period to encourage spending. After 2005, inflation shot up, in response, interest rates were increased. The financial crisis of 2008 led to an economic downturn and decrease inflation and growth. To fight this bank reduced interest rates. As India was not hit particularly hard by the crisis, inflation and growth rebounded strongly soon compared to other countries. The economy grew around than 8 percent per annum between 2009 and 2011. This led inflation to go beyond the upper limit of the inflation target range. The RBI reversed its expansionary stance. From a low of 4.75 percent in 2009, interest Edy rates gradually increased to 8 percent in 2014. The falling investment levels and the slowdown in growth since then has forced the Bank and the Monetary committee to slash interest rates regularly. Today they stand at 5.15 percent.

Characteristics of Indian economy

Meaning of underdeveloped economy A developing country or underdeveloped country is a country with a less developed industrial base and a low Human Development Index (HDI).

According to the United Nations, a country is considered as under developed if it has a real per capita income which is less than 25% of that of USA.

Countries with high per capita income, high HDI index, technologically and industrially advanced are known as developed economy. Norway, Japan, Switzerland, Australia, Germany, USA, Canada, Sweden, UK,Denmark etc. are considered as highly developed countries.

Low per capita Income

Per capita income (PCI) is the income per person per year in the country. It is equal to national income divided by population of the country. Developing economies have low levels of PCI.

Sectoral distribution of GDP

Sectoral distribution of GDP (2011-12):

• Agriculture & allied activities – 14% (was 55% in 1950-51)
• Industry – 27% (was 15% in 1950-51)
• Services – 59% (was 30% in 1950-51)

Importance of agriculture in occupational distribution

In developed countries only 2-5% of the labour force is employed in agriculture. In India around 6o% workforce is engaged in agriculture while in UK it is 1%, in USA it is 4% and in Japan 5% only.

Slow increase in agricultural Productivity

The total food output in India has increased from 51m tons in 1950-51 to 260 m tons in 2011-12. this is because of the use of modern agricultural practices, extension of irrigation, intensive methods of cultivation, agricultural support policies etc. but the productivity od land in India is still very low as compared to developed countries.

Low Capital Formation

Capital formation is the net investment in the physical and fixed capital assets in a country. Capital formation requires a high level of saving and investment. In India there is slow increase in the rate of capital formation. It indicates India is a developing country.

Slow urbanization

There is a direct link between economic development and urbanization. Urban area is one where there is a municipality, minimum population is 5000 and at least 75% of male working population is engaged in non-agricultural activities. In India 30% population is living in urban area while in USA 77%, Japan 79%, UK 89%, Australia 91%.

Slow Modernization

Modernization means structural and institutional changes in economic activity. It means advancement of technology, innovation, better management etc. Modernization is taking place in India but it is very slow as compared to developed countries.

Poor socio-economic overheads

Socio-economic indicators of development include variables such as intake of calories, literacy rate, number of doctors, level of poverty, life expectancy, IMR etc.

Useful Links

Asian Development Bank Report: Economy of India

• https://www.adb.org/countries/india/economy
• https://www.adb.org/countries/india/data

World Bank Data: India Region

• https://data.worldbank.org/country/india

India-Economy Analysis IBEF Analysis

• https://www.ibef.org/economy.aspx
• https://www.ibef.org/economy/indiasnapshot/about-india-at-a-glance Economy of India
• https://www.ibef.org/exports.aspx EXIM Data
• https://www.ibef.org/industry/indian-consumer-market.aspx Consumer Durables Data

More useful links

https://tradingeconomics.com/india/indicators