India Getting on Board

For more than half a century following Independence in 1947, India perpetuated the sad trend of its poor growing larger and larger in number every year. As we know today, India's escalating impoverishment was not irremediable. It was essentially caused by the government's imposition of wrongheaded policies to control economic activity on all fronts. It reserved ownership of companies and services in many sectors for itself, prohibited foreign investment in most activities, placed incredibly restrictive licensing procedures on businesses, overregulated the labor markets, closed the economy tight to foreign trade and maintained extremely high tax rates. In short, the government followed a suffocate-the-market approach to development, which, of course, was doomed to fail.

Fortunately, that approach started to change, grudgingly, in the mid-1980s – and more forcefully in the early 1990s. The old industrial licensing system was progressively dismantled, and other government regulation in sectors such as IT and communications underwent even deeper liberalization. Trade and foreign investment barriers were slashed, and financial reform was undertaken to allow for more credit and equity to be channeled into the private sector. Special economic zones were established to provide better infrastructure and to lighten bureaucratic burdens on businesses, and income tax rates for individuals and companies were reduced significantly.

So far the reforms have paid off handsomely. GDP is now growing at an annual rate that, if sustained, will allow average income to more than double in a decade. GDP grew 9% in 2006, making India's economy the world's third largest when compared at purchasing power parity exchange rates. Nowadays the absolute number of Indians living below the poverty line falls every year, and the middle class is becoming a formidable market that no global company can ignore. Indians are proud of what's been achieved and are optimistic about the future – and for good reason.

Huge Pending Tasks

Many policies are still in need of reform, however, if millions of Indians – almost 30% of its 1.1 billion population – are to have the opportunity to overcome the abject poverty in which they live. True, India's is now a market economy, but huge distortions and vulnerabilities remain, seriously limiting the economy's potential. Despite significant liberalization, government regulation continues to cripple economic freedom and competition. For example, labor laws designed to protect employment are inhibiting job creation in sectors like manufacturing, an area in which India should have a great advantage over other countries. Hiring and firing workers is so onerous that new jobs are being created only in areas where enforcing laws is next to impossible or where specific regimes providing the necessary flexibility have been established, such as in some service sectors. Labor rigidities also cause employers to substitute machines for manpower or to refrain from expanding production capacity. This condemns the poor to remaining in the informal economy, where productivity and incomes are very low.

Overregulation of product markets has equally perverse effects. India's entrepreneurs, acknowledged as highly creative, still suffer heavy bureaucratic burdens. Red tape constitutes a practical entry and exit barrier to many markets, impairing competition and innovation. The agricultural, retail, manufacturing and transportation sectors are only the most conspicuous examples dragged down by excessive regulation and other counterproductive government interventions that limit growth, employment and productivity.

Although India is dramatically more open to imports and investment than it was a few years ago, it continues to be more protectionist than other large emerging economies. Its competitiveness in global export markets would be greatly enhanced if it lowered the level and variance of import tariffs further and liberalized foreign investment. Government ownership of firms is still pervasive, particularly in key areas such as energy and banking. Without more private investment and competition in these sectors, India's growth could soon encounter severe bottlenecks. Prudent privatization of public enterprises, along with deeper tax reform, would strengthen the national and state governments' finances, which is necessary if there is to be sufficient investment in public infrastructure, education and health care.

That these and many other items remain on a must-do list awaiting action by India's lumbering political system could be interpreted as bad news for future development. But the fact that despite persistent and severe problems India has managed to grow so spectacularly in recent years says a lot about its economic potential. India's leaders should be able to extract the right lessons from the economy's two-decades-long evolution. They should be aware that growth has been driven mostly by those sectors where workers, entrepreneurs and firms have enjoyed the least oppressive environments in which to exercise their economic freedom.

If the world's largest democracy is truly motivated to succeed in overcoming underdevelopment and becoming a real superpower by midcentury – when it will also be the world's most populous country – then, clearly, more and more liberalization is the way to go. India can make it if it gets fully on board the globalization train.