A Bigger India Needs Bigger Thinking

[This a guest post by Matthew Schwarz. Matt is studying International Finance and Banking at The Fletcher School of Law & Diplomacy at Tufts University, where he intends to complete his Master's in International Affairs in May 2012. Before entering graduate school, he completed a Fulbright research fellowship at Vietnam National University in Hanoi, Vietnam. His current research focuses on the emergence of capital markets in South and Southeast Asia.]

The biggest democracy in the world is poised to become much bigger in the coming decades. India’s population is projected to increase from 1.2 billion today to about 1.6 billion in 2050, with the number of working age individuals alone expected to swell from 781 million to about 1 billion within the next twenty years. While emerging market investors see these figures as indications of India’s astonishing potential, the possibility of a demographic explosion is putting enormous pressure on lawmakers to develop an economic model that can withstand unprecedented demographic challenges.

Since the inception of economic reforms in 1991, the Indian government has taken a cautious approach to the economy. Demonstrating its affinity for a stable macroeconomic environment, the Reserve Bank of India has maintained meticulous controls on inward and outward capital flows, with the intention to keep inflation tolerable for the country’s growing middle class (the current episode notwithstanding). Restrictions on capital flows have perpetuated macroeconomic tranquility, but impediments to foreign investment have prevented India from fully achieving its economic potential.

While India’s economic model has created astonishing prosperity, analysts are growing increasingly doubtful that India can continue to grow so rapidly without modifying its economic model. One of the most profound consequences of India’s resistance to foreign participation in the economy and financial system is that India has not developed as strong a manufacturing sector as other emerging markets, such as China and Brazil. India’s manufacturing sector contributes a paltry 27 percent to annual output and accounts for only 19 percent of employment.

The government is well aware of the need to expand the manufacturing sector. Providing labor-intensive jobs is essential to reduce poverty and reduce India’s dependence on imports. In early June, Prime Minister Manmohan Singh unveiled an ambitious program to increase the share of output contributed by manufacturing from 16 percent to 25 percent. Four months earlier, Finance Minister Pranab Mukherjee emphasized that India needed a stronger manufacturing sector. “For sustained growth of GDP and productive employment for younger generations, it is imperative that the growth in [the] manufacturing sector picks up,” Mukherjee said.

The push for a stronger manufacturing sector is an admirable step forward, but it cannot be the only modification India incorporates to its economic strategy. Foreign investment should become the central pillar of India’s new economic strategy. Realizing the transformative impact foreign capital can have on the economy, financial system, and the legal framework, India must move beyond promoting investment, and adopt a new national economic development strategy giving foreign investment the central attention it deserves.

Bringing a new economic strategy into being will not be easy, but it is necessary to ensure a prosperous economic future. Reform will require a courageous plan featuring ambitious changes to India’s legislative framework and institutional landscape. A challenging political environment is no excuse for complacency when the stakes are so high. The challenges Indian progressives have to overcome are considerable, but not insurmountable.

Moreover, the need to act is growing increasingly imminent. Goldman Sachs estimates that India will require $1.7 trillion in infrastructure investments in the coming decade, and, in spite of its glimmering IT metropolises, India is home to more impoverished people than the entire continent of Africa. Indian lawmakers should take pride in having produced rapid economic growth for more than two decades, but significant challenges lie ahead. It is hardly time to celebrate India’s achievements.

What reforms need to be implemented to maintain a strong economy? The most obvious area for improvement is labor legislation. Laws such as the Industrial Disputes Act of 1947 and the Factories Act of 1948, not to mention dozens of subordinated regulations, are vestiges of pre-reform India. They are inconsistent with the new Indian economy, and intolerable if India wishes to create balanced and sustainable prosperity. Bringing labor regulations up to speed with the rest of the system is an essential step to encourage investment in job-creating industries.

Less obvious but equally important is the need to liberalize restrictions on debt inflows. While India’s regulatory authorities have welcomed foreign investors to participate in domestic equity markets, foreigners interested in contributing capital to infrastructure projects (mainly through debt) are subject to extensive restrictions. Because cash flows from infrastructure investments accrue over a long period of time, such restrictions have limited infrastructure development at a time when Indian competitiveness depends in large part on stronger infrastructure. Liberalizing restrictions on debt inflows is another important step to unlock the potential of foreign investment for the Indian economy.

Higher levels of foreign investment could also lead to a stronger regulatory system. When businesses become entrenched in foreign economies, foreign governments invest in their success through technical assistance programs. For India, like other emerging market economies, such investments would provide technical assistance and capacity-building programs to bring the regulations and institutions governing commercial activity in-line with international best practices. Encouraging foreign investment is the surest method to attract technical assistance from advanced economies.

How can lawmakers implement this new economic strategy, given all the obstacles embedded in the Indian political system? A strategic repositioning of this sort is far too important to be reduced to a single political gambit and needs, instead, to be implemented over time. An invigorated Parliament is one of India’s most valuable traits – but, as in all democracies, it has a tendency to dilute (and sometimes destroy) plans that are too ambitious.

To keep these ideas alive, the Ministry of Finance, in partnership with think tanks from India, the United States, and Europe, needs to develop a roadmap for foreign investment in India featuring the reforms outlined above and open to continuous improvement. Such a roadmap should be endorsed by India’s development partners, honed over time, and implemented whenever political conditions allow. Bringing a new vision for the Indian economy to life will require persistence and continuous attention from everyone – politicians, intellectuals, and citizens – committed to ensuring strong economic growth going forward.

A new economic strategy based on foreign investment is essential for India to maximize its demographic dividend. A growing population will demand more jobs, better infrastructure, and a modern regulatory framework. Foreign investment can play an important role in promoting all three, so long as Indian lawmakers set aside their reservations and finally start thinking big.