Creating Growth Through its States, How India Can Become A Long Term Driver of Economic Growth

At the close of the 20th century it was taken as self-evident that democracy, and the democratic capitalism that invariably accompanied it represented the most superior system for mankind. In the 21st century, China has shaken that faith with its own brand of authoritarian capitalism, and many have pointed to India as an example of how democracy hinders rather than promotes development. While in the past year, China’s GDP has plummeted and with it its stock market and its currency, pessimists should be wary of too quickly calling an end to China’s ongoing rise. While it is clear that there are problems in the system of enterprise that underlies its success, the China story is yet to fully play out. What is also clear is that India is beginning to put in place the foundations of a system of enterprise that can deliver the type of vibrant, scaled and high growth economy that Indians need and the world will benefit from. Again, optimists should be wary of reading the wrong things into this too; for example that India’s success will displace China. For India, its rise is a multi-decade venture. The key to India’s successful economic rise lies in a combination of a macro top down approach which encompasses drawing foreign capital in and a ground up approach to unlock the value of its people and that requires unlocking the value of the states of India. As highlighted in July’s Sign of the Times, the economies of India vary enormously between its regions and given these differences, India will need to implement different models of growth for different clusters of states based on their political, economic and demographic characteristics. Fortunately, there are proven growth strategies that India can learn from and Asia has many lessons to offer.

Earlier this year, the World Bank suggested that India’s GDP growth would outpace China’s in 2015, making it the world’s fastest growing large economy far sooner than many had expected. India’s ability to maintain high growth over the medium to long term is dependent on creating a system of enterprise that is self-sustaining. As China’s cost structure continues to rise and its transition to a consumer-led or a value added led economy is slow in coming, India is being viewed by many as China’s natural successor as the world’s low-cost factory; India is widely expected to transform into an outsourced manufacturing destination leveraging its large and relatively low-cost work force much like China has done for the last three decades. However, the current slowdown in China’s growth and the challenges it is facing in restructuring its economy away from investment, manufacturing and exports suggest that while following in China’s footsteps is commendable but it would be prudent to pursue parallel strategies that take into account the particular characteristics of India.“India’s ability to maintain high rates of GDP growth over the medium to long term is dependent on creating a system of enterprise that is self-sustaining.” Analysing the success of other countries that have successfully created sustainable systems of enterprise during the past 50 years, understanding the underlying factors that resulted in their success and subsequently identifying clusters of Indian states where these models can be applied can play an important role in shaping India’s policy decisions over the course of the next decade. For India’s people to fully reap the country’s potential democratic dividend to create prosperity, the country will need to implement a range of sustainable long-term economic growth models..

In July’s Sign of the Times, we divided India’s states into four broad categories based on a series of economic, demographic and human development-based indicators. These are: (a) the Outperformer States (or I-5 states), which are the country’s growth engine, and account for 40% of India’s GDP and 57% of its registered companies, (b) the New Frontier States, which although historically impoverished, have witnessed rapid growth over the last decade, (c) the Old Economy States that are primarily in South India and have a long history of development but have experienced an economic slow-down over the last five years, and (d) the Laggard States, which are highly populous and impoverished and lack the basic infrastructure required to meaningfully participate in India’s growth story.With 47% of the population still employed in agriculture and approximately only 30% of GDP generated by industry, India will clearly need to industrialise to create sustainable growth and prosperity. The wide economic disparities between these states – the GDP per capita of Maharashtra, an I-5 state – is approximately 10x that of Uttar Pradesh, a laggard state – mean that in order for India’s growth to be inclusive, the Modi government would need to tailor development policies for each of these clusters. Designing and implementing multiple policy frameworks within one country is not an easy task, but there are growth models India can adopt from countries that have in the past few decades successfully industrialised and transformed their economies, particularly China, Taiwan, South Korea and Japan. Each of these countries leveraged different underlying factors to drive economic development and the lessons from the successes of each growth strategy are potentially highly applicable to different Indian states.

Successful Growth Models Among Asian Countries For India, the key challenge is clearly one of industrialisation. With 47% of the population still employed in agriculture and approximately only 30% of GDP generated by industry, India will clearly need to industrialise to create sustainable growth and prosperity. Since the 1960s, a number of Asian countries have successfully made the transition to modern, industrialised and post-industrial economies, delivering high growth and increasing standards of living to its citizens, with countries adopting different strategies over time dependent on their level of development and certain exogenous factors. Among these, four strategies stand out as potential blueprints to unlocking the potential of India’s different states. They span a range of development levels not unlike those found in India today and provide lessons not just on basic industrialisation, but on the role of infrastructure in building value, scaling value added industries, attracting foreign capital, working with the private sector, and on leveraging public industrial policy to drive growth:

1. China’s Scaled Industrialisation Mode

Overview - Low Cost Manufacturing Driven Growth. China’s rapid economic growth over the last two and a half decades is perhaps one of the most remarkable economic transformations in recent times. The country emerged as the world’s second largest economy, with GDP expanding by approximately 10% per annum between 1991 and 2011, and nominal GDP per capita increasing from US$366 to US$5,429 during the same period. China’s share of the global manufacturing economy, which was less than 5% in 1990, rose to approximately 19% in 2010 as China emerged as the world’s most favoured destination for outsourced manufacturing. Importantly, between 1995 and 2010, investment as a percentage of GDP went above 40% for 10 of the 15 years, as the massive investments in industrial and physical infrastructure created millions of jobs and drove the creation of scaled industries in steel, cement, construction, engineering and others as cornerstones of China’s economy alongside manufactured exports.

Key Drivers of China’s Growth. China’s economic growth was driven by its transformation into a global manufacturing hub, a transformation made possible by the country’s demographic fundamentals. China has long enjoyed the world’s largest workforce, driven by a birth rate that as late as 1978 averaged 5.2 per woman. This massive workforce supported the build-out of labour intensive industries at previously unprecedented levels of scale: between 1990 and 2010 well over 70% of China’s work force was concentrated in labour intensive sectors, including steel, textiles, and automobiles among others. China’s massive workforce also ensured the continuing availability of low cost labour, keeping costs internationally competitive. Between 1982 and 1997, labour wages in China grew by only 0.1% per year, while productivity nearly tripled during the same period. The build-out of scaled industries required the mobilisation of significant capital and expertise, and international participation had an important role to play in the industrialisation of China. Trade and economic reforms and the creation of Special Economic Zones (SEZs) resulted in a large number of foreign-invested entities (FIEs) flocking to China. Cumulative FDI inflows between 1990 and 2011 exceeded US$ 1 trillion, with FIEs contribution to the country’s industrial output increased from a mere 2% to 26% over the same period.

The Role of the Government. In China’s economic development model, the state plays a central role in economic activity, with initially in excess of 50% of GDP being generated by state owned enterprises and a system of five year plans setting output and production targets. While these types of government involvement are not transferable to India today, there are other, more transferable policies that played a critical role in China’s economic development, such as the creation of SEZs to transform the country’s manufacturing sector. The government implemented a number policies to facilitate foreign capital flows in the initial four SEZs set up in China’s southern coastal zone, including a relaxation of labour laws and foreign investment regulations as well as the promotion of technology transfers into manufacturing firms. With the economies of Guangdong and Fujian, where the SEZs were located, growing by 16% and 15% respectively between 1985 and 1990, the SEZ program was expanded at on massive scale with a further 11 SEZs, which in total accounted for nearly 90% of China’s total exports by 1985. With the majority of FDI and other private investments going into manufacturing, the focus of public investment was on physical infrastructure. Between 1992 and 2011, China overtook the United States as the world’s largest infrastructure investor. Infrastructure investment as a percentage of GDP averaged 8.5% and this enabled the largest build-out of infrastructure in history during this period. Another key policy implemented by the government was decentralised decision-making, allowing provincial governments to design their own policies with regards to investment, pricing, taxation, labour and land management. This decentralisation significantly accelerated capital formation as regional domestic and foreign investments no longer required consultation with or approvals by the central government.

2. Taiwan: Growth Driven by High-Tech Industries

Overview - The Rise of High Tech Industries in the 1980s and 1990s. Following a period of rapid economic expansion in the 1950s and 60s, driven by initial industrialisation and manufacturing exports, Taiwan’s development focus during the 1980s shifted to the build out of high-value technology industries. A combination of public and private sector efforts helped the economy transition from a heavy industry-driven economy to a global leader in the production of high-tech products. Median GDP growth between 1980 and 1995 was approximately 8%, and GDP per capita grew from US$4,000 to US$15,000, as Taiwan successfully avoided the middle income trap that most countries face following a period of rapid industrialisation and real income growth

Key Drivers of Taiwan’s Growth. Taiwan’s continuing rapid economic expansion between 1980 and 1995 was driven by the growth of high-tech industries including consumer electronics, automobiles, and mechanical and electrical engineering. In developing these sectors, the country adopted an industry hub strategy, with the Hsinchu Science and Technology Industrial Park near Taipei being instrumental in Taiwan’s transformation. Modelled along the lines of Silicon Valley in the United States, the park, created in 1980, clustered academia and private enterprise in an environment conducive to research and development (R&D), attracting high-tech companies and entrepreneurs via a number of economic and infrastructure-related incentives. Due to these measures, the total export value of companies located there increased from US$4bn to US$16bn between 1986 and 2000. Another key driver of Taiwan’s high tech growth was the creation of innovation alliances among private sector firms, with small and medium enterprises lacking the capital and resources to invest in large-scale R&D projects on their own, pooling their resources for investment. These alliances were critical in Taiwan’s advances and leadership in notebook computers, high-definition televisions, and communications equipment. Finally, as in China’s industrialisation, foreign investment provided another key growth driver: Between 1991 and 2000, FDI inflows into Taiwan amounted to US$18bn, and the capital and production know-how invested by foreign institutions not only provided a boost for high-tech production in the country, but also resulted in domestic firms increasing investment in response to international competition

The Role of the Government. Government policy was instrumental in the execution of country’s growth strategy during this period, implementing a range of measures promoting high-tech manufacturing. Having founded the Industrial Research and Technology Institute (ITRI) as early as 1973 to provide support to private sector companies to upgrade their manufacturing capabilities, the government kick-started Taiwan’s high tech sectors with creation of the Hsinchu Science and Technology Industrial Park, investing approximately US$550mn between 1980 and 1995 to build out of the park’s infrastructure and facilities. Further, the liberalisation of the country’s economy was another critical policy action implemented by the Taiwanese government. . By easing restrictions on foreign investment, the government enabled the mobilisation of financial resources required to drive innovation and R&D.

3. Japan: Private-Public Partnership for Growth and Innovation

Overview - Japan’s Post War Economic Miracle. Japan’s Post War Economic Miracle covers a nearly 30 year time span between 1946 and 1973, where the economy expanded at an average 8.8% per year. Sectors including manufacturing and mining, as well as construction, which had slowed to a standstill during the Second World War expanded by 13% and 11% annually respectively between 1953 and 1965, while the infrastructure sector expanded by 12% annually during the same period. These sectors predictably were not only major drivers of economic growth, they were also major drivers of employment, accounting for approximately 40% of the country’s labour force during the mid-1960s.

Key Drivers of Japan’s Growth. Similar to China’s growth, Japan’s post-war economic miracle was driven by mass industrialisation. Investment in fixed capital as a percentage of GDP rose from approximately 20% in the 1950s to more than 30% in the 1960s and 1970s, a period during which Japan leveraged its educated and highly efficient labour force to build out advanced industrial capacity, in a two-step process: During the initial phase the government encouraged companies to license or import foreign technology to establish and scale industrial capacity. During the next phase of growth, emphasis was placed on scientific excellence, R&D and innovation as tools for economic advancement. Beginning in the late 1960s international technologies were increasingly replaced with domestic innovation, enabling Japan to assume leadership positions across a number of industries, including textiles, automobiles, electronics and machine equipment.

The Role of the Government. Government involvement in Japan’s growth was key to the execution of the two step growth plan. During the first phase, Japan’s Ministry of Labour implemented a number of important policy actions to leverage the country’s labour force, establishing parity between large corporations and labourers on key issues like wage equality and tenure. During the second phase of its economic development, the Ministry of International Trade and Industry (MITI) became the key instrument of the government’s economic development efforts, with the ministry funding most of the country’s public and much of its private sector research and development efforts. Importantly, across both phases of economic development, the government applied an ‘indicative planning approach’, collaborating with large Japanese corporations and trading houses on executing development goals. While government institutions like the Ministry of Labour and MITI played an important role in shaping industrial policy, they aligned their targets with those of the large Japanese trading houses, and did not intervene as these corporations worked towards achieving them.

4. South Korea: Scaling Heavy Industries with Foreign Capital

Overview - Rapid Industrialisation Between 1960 and 1990: Much like Japan in the immediate aftermath of the Second World War, South Korea too was a highly impoverished nation following the Korean War that lasted from 1950 to 1953. By the early 1960s, however, the country transitioned towards a democratic system and as the government opened up its economy, growth soared. Thanks to a focus on heavy industry that leveraged a skilled but low cost workforce at a time when countries like Japan were transitioning to high technology, real GDP growth averaged 8%, between 1962 and 1989, while nominal GDP per capita increased 50-fold from US$104 to US$5,438. The share of the country’s manufacturing sector rose from 14% of GDP to a little over 30% during the same period, and its domestic savings rate grew from 3% to 36%.

Key Drivers of South Korea’s Growth. With both domestic consumption and savings negligible following the Korean War, the government adopted an outward-looking strategy that focused on labour-driven manufactured exports. The government successfully leveraged a skilled but under-employed work force in order to gain a competitive advantage in a number of export-driven heavy industries including automotive, steel, shipbuilding and heavy machinery. In the absence of sufficient domestic capital, foreign investment was a component in South Korea’s development strategy, with the government successfully mobilising both foreign borrowings and investment. FDI inflows between 1962 and 1989 amounted to approximately US$7bn, with more than 60% of this being directed towards the manufacturing sector. The combined impact of increased labour force participation and foreign capital resulted in South Korea’s exports rising from US$33m in 1960 to US$61bn in 1989, a 20% average compound annual growth rate sustained for nearly 30 years.

The Role of the Government. The start of South Korea’s growth spurt was the industrial policy adopted by the government in the 1960s which was very similar to the one implemented by Japan a decade earlier. One key difference was the increased cooperation, with a small number of large South Korean conglomerates (also known as ‘chaebols’). While Japan’s scaled conglomerates were dismantled by the Allies following the end of the war, South Korean groups became the key executors of industrial policy and the key recipients of government support with the top four chaebol generating 90% of total corporate profits in South Korea to this day. In terms of attracting foreign capital, the government drove a series of reforms providing foreign investors with tax holidays, ensuring equal treatment alongside domestic firms and providing guarantees of profit remittances. Foreign policy also played a key role attracting capital: diplomatic relations were established with Japan, for example, to ease and promote Japanese investment into the country’s manufacturing sector.

Adopting These Growth Models in India Understanding the applicability of the above growth models’ policies in India requires a deeper understanding of the characteristics of the states of India and the industry clusters that already exist within the country. The adoption of growth strategies on a regional level in India must, therefore, not only recognise the potential economic impact that the strategy can have on a state’s economy in the future, but also the state’s political, geographic and economic reality today. Given this, a potential adoption plan for the different growth models could be as follows

Successfully implementing policies to execute growth strategies along the lines described above has the potential to transform each region and India as a whole. If the above regions are able to successfully implement the versions of successful growth models and recreate the development benefits they brought their original implementers, all of India will be fundamentally transformed over the next decade. The transformation of India into an industry-driven country that is the world’s factory for everything from textiles to consumer electronics to automobiles could further accelerate the country’s growth trajectory over the next decade. Rather than growing at the 7% growth rate forecast by economists, India could put itself on a 9% growth path between now and 2025.

Implications for Policy Makers

Regardless of the growth model, government will have an active and important role to play in the development and execution of economic growth, although the nature of the role can vary widely from model to model. Despite these variations there are a number of fundamental core actions the India’s government will need to take in any case, many of which run counter to decades of local practises and trends. These include:

• Central Policy Makers Incentivising State Governments. Successfully implementing a series of growth models on a state and regional level will require not just government decentralisation but also local cooperation in a high diverse and politically fragmented country. With the incumbent BJP government in power in only nine of India’s 31 states, large-scale reforms may well be unpopular across much of the country. In order to ensure that the central policies that it is passing at the centre are actually translating into growth, the Modi government may need to create a series of incentives to bring state governments on board with its policy agenda, including both traditional incentives such as debt-relief packages and employment schemes in exchange for performance as well as more innovative methods including partnering with corporate state champions to pursue the cause, naming and shaming laggards by publishing development metrics, and supporting the national advancement of local politicians that deliver growth, regardless of their party affiliations.

• Aligning Private and Public Interests: Declaring Process, Streamlining the Bureaucracy.Private-public projects have been in place in India since as early as 1991, but the model has yet to achieve Japan and South Korea’s level of success in terms of delivering economic growth. One of the factors that is missing is the central clout that MITI, for example, enjoyed at the height of its power. Another factor that may help India is an independent regulator entrusted with ensuring alignment between the public and private sector. More importantly, bureaucracy and red tape, particularly in matter such as environmental and land clearances, which are critical to infrastructure projects have been a major reason for the failure of many partnerships.With a US$1 trillion infrastructure-funding gap expected in India over the next five years, there is tremendous potential scope for partnership projects. However this will require a relook at the use of political power to manage change and also a fundamental overhaul of key regulatory agencies, including additional funding to increase resources, the creation of fast-track processes, the implementation of bureaucratic accountability and the creation of independent controls and oversight to monitor regulatory performance.

• Successfully Mobilising Foreign Investment. India has the potential to be one of the most attractive destinations for foreign direct investment (FDI) in the world on account of the unique growth opportunity it represents. However, inbound FDI over the last decade amounted to a total of US$238bncompared to China’s FDI of US$1.3tn over the same period. India’s ability to attract FDI has been constrained by a number of high-profile disputes between the government and large multinationals that have damaged its reputation as a “safe” destination for foreign capital. These have included issues regarding irregular and retrospective taxation (with Vodafone, Shell and Nokia) and disputes over food safety quality (Nestle, GSK Healthcare) between India’s food testing regulator and foreign corporations. The Modi government since 2014 has begun to turnaround India’s image to be an attractive destination for foreign direct investment, and has secured commitments from foreign governments of US$170bn to date. For these to translate into reality, beyond solving historical issues real opportunities will need to be created. This will likely require initiatives including the creation of industrial mega projects such as industrial corridors and smart cities, large-scale privatisations in the natural resources, financial services and utilities sectors, and the encouragement of scaled infrastructure investments in ports, airports, distribution and logistics sectors across a wide range of states.

Key Conclusions: Democracy Requires Competent Execution and Partnership Capital

Successfully implementing one national strategy, let alone a handful of simultaneous regional strategies, is a tall order. Having successfully laid the groundwork for a set of high growth industrial growth policies, India will still need to execute a diverse series of complex and multi-decade strategies that integrate all of the domestic and international, and public and private moving pieces laid out above. For India to maximise the speed of execution and ensure the highest probability of success it will need to collaborate with a series of partners that provide capital, resources and expertise at scale. In many ways the ideal partners for each growth model are the original implementers: not only do they have the most experience and successful track record of execution, their past successes have transformed their economies to the point where a partnership with India provides them with attractive benefits as well. The idea of “Partnership Capital” embodies the notion of a business partner with the capital to make a difference. Indicative areas for such partnership capital include:

• China Infrastructure and Investment Partnership. China is the only country in the world that is an appropriate benchmark for India in terms of the total infrastructure build out required, both in terms of scope and scale. While other countries have successfully industrialised, no other ones have faced the challenges in terms of primary infrastructure build-out and modernisation requirements. Moreover, following 30 years of development, China has built scaled domestic industries around infrastructure, including engineering, building materials, construction and real estate. With domestic demand for infrastructure slowing and parts of the country suffering from a build-out overhand, India provides an attractive business opportunity for sectors that constitute a large part of China’s overall economy. A potential partnership between India and China could include the joint conception and execution of scaled mega projects, ranging from hydro-electric projects to the build-out of deep-water port facilities, (which China is already pursuing in other countries in the region), with China providing capital, planning expertise and execution resources in the form of identifying and coordinating corporate champions to expand to India. Given the history and potential for future disputes on territorial matters, India is clearly not going to handover key parts of its infrastructure to China. So, any partnership requires the national interest to be safeguarded through ownership and control mechanisms that separate investment from asset control.

• Taiwanese Manufacturing Clusters. Taiwan’s own strategy of building the country into a tech-manufacturing hub is instructive for India, despite the difference in scale between the two. Being multiples larger than Taiwan population and geography-wise, India will clearly need to build multiple manufacturing clusters across several states in parallel, each one potentially the size of Taiwan’s, making the latter a potential execution blueprint. Taiwan’s own technology manufacturing has long since moved further up the value chain to focus on high end products like semi-conductors, with electronic manufacturing services having migrated to the Chinese mainland. As costs in China’s coastal and southern provinces continue to rise, Taiwanese manufacturers will need to identify the next wave of low cost manufacturing destinations that can deliver massive scale, making India an ideal partner. A potential Taiwanese-Indian partnership would include elements at both the corporate and government level, with the government advising on the creation of hubs and corporates being attracted as core anchor tenants to quickly scale the eco-system required to make them successful.

• South Korean Heavy Industry Investments.During its own economic transition, South Korea has gone from being an importer of capital to an exporter, with over $35bn in overseas direct investment last year, against FDI of US$11bn. With increasing prosperity, it has also lost is advantage as a low cost manufacturer, hurting its competitiveness in the heavy industries that created the wealth to begin with. India represents a chance for South Korean companies to regain competitiveness across a wide range of sectors including steel, machinery, shipbuilding and others, where its capital and expertise can be combined with India’s wage advantage and large labour force. Given the importance of South Korea’s chaebol both in absolute economic terms and in terms of the execution of the countries growth policy, a partnership between India and South Korea could focus on the forging of long term investing and business alliance with the country’s largest industrial groups, providing these companies with open access to the Indian market and policy support for a wide range of investments.

• Japanese Research and Technology Partnerships. Finally, Japan is a strong potential partner for investment and innovation. India has already built a series of high tech hubs focused on software and services that are highly competitive based on its educated and skilled yet low cost workforces. Japan on the other hand, while having led the world in sectors such as consumer electronics and robotics has fallen or is starting to fall behind in key growth industries such as internet technologies, mobile communications and next generation software. India provides an attractive investment destination for Japanese corporates to build IP in critical technology sectors and augment their own capabilities. An Indian-Japanese partnership could include actions at both the government and corporate level, with the Japanese government advising on R&D coordination between the public and private sector in India as well as providing R&D funding and investments and Japanese corporates establishing scaled research centres in India’s established technology hubs as well as founding new hubs.

Of course India’s development will require far more than just four national level industrial partnerships. The United States for example is the world’s largest overseas investor and Canadian, Australian and Middle Eastern countries have displayed an increasing appetite for exposure to India.“So is China bound to go on winning? No, because while the Indian system is a daily soap opera of small crises, the big crisis of China’s self-contradictory system of Leninist capitalism is yet to come. And no, again, because India is a free country…Surely that free expression of human individuality must win out in the end”
Timothy Garton Ash, The Globe & Mail, Jan-2015 Further, countries such as Germany in high-end manufacturing or Scandinavian countries in technology also have the potential to be industrial and investing partners. If India is to succeed in creating a diversified industrial economy, it will need to attract financial and human capital as well as expertise from the widest possible base of sources, opening itself up to all. If India is able to do this, it will finally reap its democratic dividend and be able to deliver on the promise of wealth and security of its 1.2bn citizens.There are clearly many things that have held India back during the past 50 years. The time has come for the country and its leaders to demonstrate that democracy was not one of them.

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