Mr Modi will encounter a tough economic climate in his second term. The combination of heightened expectations and a weaker global economy will act as headwinds. Plus, he can no longer deflect the blame to past leaders. A hodgepodge of government schemes, without a clear underlying philosophy, will only expand the reach of the government and exacerbate the fiscal deficit without providing the desired economic and social benefits. The window on India’s demographic dividend is also fast closing.
Mr Modi will likely have a set of welfare priorities, but there are economic reforms that he will have to push to get the Indian economy out of its current slowdown. Wealth must first be created before it can be distributed. The country is stuck in what is called the ‘middle-income trap’, an economic paradox where a country attains a certain level of income but then gets stuck at that level. According to a World Bank study, there were 101 countries deemed to be middle-income countries in the 1960s, but only 13 have managed to break out of the middle-income trap and achieve high-income levels by 2011. Only a few countries have successfully made the transition from resource-driven growth fuelled by low -skilled cheap labour to growth based on innovation and rapidly increasing productivity. This is the trap facing India. Will it remain stuck here for the foreseeable future or will it adopt the next generation of reforms required to catapult the economy out of this quagmire.
The World Bank defines countries with per capita gross national income (GNI) between $996 and $3,895 as lower-middle-income countries, between $3,896 and under $12,055 as upper-middle-income countries, and higher income countries with per capita income greater than $12,006. India, with a per capita income of $1,795, falls in the lower middle-income category along with countries like Indonesia, Philippines, Egypt, Ghana and Kenya.
And while India has made significant progress in reducing poverty and moving millions into the middle class after the economic liberalisation of 1991, its growth has now stalled. Since 2011, the country is struggling to build and maintain international competitiveness. There are tangible signs that personal consumption, which fuelled much of India’s growth over the past ten years, is slowing down. Sales of consumer goods, cars, two-wheelers, durable consumption goods have all slowed down to multi-year lows. Net profits for companies (excluding financials) are down 18% from last year, bank credit has stagnated, and a crop glut has seen farm incomes drop.
Even if India continues to grow at an annual rate of 7%, it will take at a minimum thirty years to reach the per capita income level of $12,006 –the current World Bank level to get out of the middle-income trap. Of course, by then the goal post would have shifted, and the per capita income required to get out of the middle-income category will have risen substantially to about $ 16,000. For India to have any chance of escaping the middle-income trap would require a GDP growth rate of almost 15% every year for the next twenty years. Even a more realistic goal of moving from a lower-middle-class to a higher middle-class country in ten years would require a growth rate of around 10% per year. A daunting task to say the least given that GDP growth has exceeded 10% only once in the country’s history.
Mr Modi appears to be a fan of the East Asian model of economic growth that countries like Japan, Singapore, South Korea, and Taiwan followed to get themselves out of the middle-income trap. This model, also known as state-sponsored capitalism, is an economic system in which a strong and efficient central government makes large investments in priority sectors to stimulate the growth of private sector companies. South Korea did it for the automobile sector, Taiwan for its semiconductor sector, and Singapore for its financial services sector. These successes notwithstanding, there are clear risks to following such a model. Everything from choosing priority sectors, to the amount of investment, and eventually which private companies to promote, is controlled by the government and the bureaucracy. Given the scope and complexity of state intervention required and the extractive nature of this process, there is a risk to both democracy and free-market competitive capitalism.
The other option for Mr Modi is to emulate Western-style capitalism where the forces of a free and competitive market determine winners and losers and not the government. Priority sectors are not defined by bureaucrats or politicians but by the demands of a free market. If people want more apples, then private entrepreneurs sensing a profit opportunity will invest in the apple-growing industry. This model requires minimum government intervention, free and unfettered flow of capital, and strict enforcement of contracts. Technology services, India’s most successful sector, developed without any state sponsorship.
Much of India’s informal sector is a free market of small businesses that grow to meet the demands of the local population. If there is construction activity somewhere, an entrepreneur sensing the need for a tea stall soon opens one up. This is western-style capitalism and free unregulated markets at their very best. Chandni Chowk, the biggest wholesale market in India, is a free, unregulated market, that has been operating effectively for decades without state intervention.
Where is India headed under Mr Modi—a free market style economy or one that has strong elements of state guidance? Given his authoritarian style, Mr Modi will likely lean towards the East Asian development model of state-sponsored capitalism. He has long been an admirer of Mr Lee Kuan Yew, the Singapore strongman who used state-sponsored capitalism to move his country from low income to high income. East Asian countries like Korea and Japan that Mr Modi regularly visited during his post-2002 ban from travelling to the US and Europe, have had a strong influence on him. He has also been unfavourably inclined towards western-style economists like Raghuram Rajan, Arvind Subramanian, and Arvind Panagariya who were all allowed to leave after short stints in the first Modi government.
India should, therefore, expect a lot of top-down economic policy over the next five years–a combination of state capitalism and strong government political control, with the state dictating which sectors get priority investment, and then permitting a selected group of private companies to operate in this space. While there will be private ownership of wealth and factors of production, expect the state’s role and influence over economic development to intensify through the Niti Ayog and the Ministry of Finance.
Will this model work for India, as it did for Japan, Singapore, Korea and China? Mr Lee Kuan Yew was a trained economist and had a deep understanding of the complexities of an economic system. Mr Modi, on the other hand, doesn’t have the depth of academic training to understand the nuances of managing a complex system like an economy. The raw wisdom that allows him to connect with people and win elections has led to disastrous economic policies like demonetisation. Secondly, East Asian style capitalism works well for small countries without deeply entrenched and conflicting interests. In India, with its history of reservations and subsidies, there are too many entrenched groups for politicians to ignore. Everyone accepts that the agriculture sector in India is grossly inefficient, yet it keeps attracting substantial subsidies and investment capital from the government. Thirdly, much of the growth in these East Asian countries has been built on large amounts of debt. China’s corporate debt, the highest in the world, is a staggering 282% of its GDP. Several large Chinese companies have recently defaulted and entire sectors, like real estate, that were once targeted to be priority sectors by the government, lie in ruins. Japanese and Korean companies also carry large amounts of bad debt, most of it the result of government pushing businesses into unviable priority sectors. Additionally, East Asian countries built their economies on the backs of a robust manufacturing sector and rapid growth in exports. India has missed the bus on developing a manufacturing ecosystem, and its exports are stagnating.
State-sponsored capitalism may sound good in theory and may have some redeeming features, but it is a series of hits and misses. China’s ‘miracle economy’ is now in trouble. The Shanghai Exchange stock index has declined by more than 50 % since its peak in2007, and economic growth is consistently below 6.5%– the point at which unemployment begins to rise dramatically. And there is an estimated US$1 trillion worth of bad loans in the Chinese financial system. Japan’s GDP growth has averaged less than 1% since 2002. Likewise, Korean GDP growth has crossed 2% only once since 2002. The East Asian state-sponsored capitalism model is showing cracks and appears inefficient, wasteful and, increasingly unsustainable. The consequence of such a policy is eventually not economic growth but clientelism, corruption, and the misallocation of resources. And a country like India, with scare capital resources, cannot afford such misses.
To get out of the middle-income trap, India must change from an imitative economy to an innovative economy. Top-down transformation won’t work –the economy needs to blossom from below. Such a transformation requires the elimination of the regulatory and bureaucratic obstacles that gag entrepreneurial activity. If Mr Modi is serious about transforming India, he needs a Ministry of Deregulation tasked with freeing the economy from burdensome, duplicative and useless regulations and allowing the innovative spirits of its people and their love for free markets (as exemplified by its informal sector) to unleash economic growth. Mr Modi should focus the energies of his government not in trying to “manage” the economy but in creating strong institutions – particularly a reliable system of property rights, dispute resolution, contract enforcement and ‘rule of law’. A growing economy creates the wealth required to support welfare. A slow economy beggars all.
This is the challenge that faces Mr Modi in his second term. How he manages to get the economy moving, and getting India on a sustained path out of the middle-income trap, will define his legacy, and more importantly, the immediate future of this country. Will he allow the science of economics backed by three centuries of evidence to transform India, or will he fall victim to short-term populism? Mr Rahul Gandhi may not have been a great campaigner, but he was spot on when he pointed out that the benefits from the 1991 economic reforms have run their course and that it is time to install the next generation of economic liberalisation reforms.
Next week I provide specific policy prescriptions for economic liberalisation that Mr Modi should prioritise to get the economy moving.