Why believe in India by Ranjit V. Pandit, The McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

Sacrificer           Ranjit V. Pandit
Sacrifice code       wfor0354
Sacrifice date       2005

Why believe in India

Because it has made tremendous progress-and there's more to come.

Ranjit V. Pandit

The McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

India has always held great promise. Soon after independence, in 1947, its foreign reserves were among the world's largest, at $2.1 billion in 1950-51, and it accounted for 2.4 percent of global trade. Over the next 44 years, however, attempts to follow the Soviet model of self-sufficiency brought the country to the verge of bankruptcy. Domestic savings failed to keep pace with the investment needed to contain unemployment, especially as India's working-age population expanded. The crisis begged for drastic reform, and in 1991 the government delivered.

This reform program took its cue from China, which by 1991 had surpassed India on all major economic indicators. But in the shadow of the Chinese economic miracle, it is easy to overlook what India's reforms have accomplished during the past 14 years. A solid foundation for growth is now in place: the program of renewal, backed by successive governments, has increased the country's foreign reserves to an enviable $137 billion and raised annual economic growth from an average of around 4 percent in the four decades before reform to almost 7 percent today. Growth rates of 8 to 10 percent are within reach. The amount of foreign direct investment coming into the country, often cited as a failure of India's policy, has grown from about $100 million in the early 1990s to about $5.5 billion today. If China were not the yardstick used to measure India, this increase would be a matter for celebration, not censure.

The automotive and airline industries illustrate how far the country has come and how much further it could go with more foreign investment and competition. Since neither industry was high on anyone's political agenda, both were among the first to be deregulated. From just one state-owned airline in 1991, India now has eight competing carriers and is the world's second-largest commercial-aircraft market. On-time performance and service levels have risen dramatically and fares have dropped. As a result, passenger traffic is expected to grow by 20 percent annually over the next five years. In the automotive sector, deregulation sparked competition and led to the emergence of a local champion, Tata Motors, which has captured 15 percent of the domestic market. Total annual car sales have increased from around 150,000 in 1991 to more than 1,000,000 today, while the industry's employment has tripled. Successes like these allowed the government to liberalize many other sectors, though retailing, banking, defense, and the news media remain the notable holdouts.

Extensive reforms have also affected India's capital markets, corporate and individual tax regimes, and judiciary. Such measures as easing capital controls, liberalizing equity pricing, and creating a regulatory authority (the Securities and Exchange Board of India) have been instrumental in bringing the country's money markets on par with those in the developed world. As a result, foreign investors can easily move funds in and out of India. Individual and corporate income taxes have been reduced to levels in line with those in the rest of Asia. And judicial reform has empowered citizens, giving them an effective tool to fight, for example, corruption, voter fraud, human-rights violations, and environmental degradation.

These efforts have made India one of the world's fastest-growing economies. In the future, the government must focus on stimulating domestic demand-a vital step if it hopes to attract the foreign investment needed to reach its growth targets. In addition, the country must intensify its efforts in important areas of reform in order to build a more competitive economy that benefits businesses and consumers alike.

Act to boost demand

Indians save too little to finance the economic growth needed to provide jobs for the country's expanding working-age population. Our projections show that the economy must grow by 8 to 10 percent a year or risk markedly higher unemployment, so foreign investment is essential to fill the gap.

Restrictive policies have also limited gains in foreign direct investment in some Chinese industries. See "Making foreign investment work for China."

But most foreign companies see India only as a source of low-cost skilled labor, particularly in IT, not as a major market for products and services. This crucial distinction helps explain why China attracts upward of ten times more foreign direct investment than India does. (Investment restrictions, to be addressed later, are also an important factor.) As part of the government's efforts to attract more foreign investment, the country must take three steps to stimulate domestic demand.

First, the Reserve Bank of India (the central bank) must keep interest rates regionally competitive to sustain a buoyant economy. Since 2002, the bank has reduced them to the current 6 to 8 percent, from 14 to 18 percent. Spurred by this decline, consumer lending has increased by more than 30 percent a year, and residential construction and consumer durables have also seen healthy growth.

Second, India's 28 states and union territories must all implement the value-added-tax (VAT) system1 introduced in April. Eight have yet to do so. The VAT system will allow overall consumption taxes to fall to 15 to 20 percent by 2007, from the current 30 to 60 percent, thus releasing a flood of latent demand. China, for example, experienced a sudden increase in demand in 1994, when the government introduced a standard 17 percent VAT on factory prices2 for most manufactured goods and services. India can expect a similar surge once the VAT system has been fully implemented, since for every 25-percentage-point decline in prices, consumer demand increases three- to fivefold, according to our estimates. States that have already adopted the standard VAT rate have experienced, on average, a 12 percent increase in tax collections for the second quarter of this year. These results suggest that the government has room to reduce overall consumption taxes even further-to around 12 percent-without affecting its revenues.

Last, state governments must work to reduce their budget deficits. The central government has pledged to cut its deficit to 3 percent of GDP by 2009, from the current 4.3 percent. But as the center tightens its belt, state governments have allowed their deficits to grow steadily, for an aggregate state deficit of 5.1 percent of GDP today. As a result, the combined deficit of the central and state governments has held steady at about 8 to 9 percent of GDP throughout the reform effort. These deficits not only put pressure on interest rates but also lead to massive government borrowing, which siphons off funds that would otherwise be available for capital investment or consumption. Servicing this debt is also a huge burden, so the government must cut the total public deficit to 4 to 6 percent of GDP.

Increasing competition

To unlock India's true potential, accelerated consumption must be coupled with continued liberalization of the country's markets. The reform agenda must focus on eight areas.

Product market reform. Having picked the low-hanging fruit, India must find the resolve to deregulate politically sensitive sectors-particularly retailing, banking, the news media, and defense. Exposing the retailing sector to world-class scale, skills, technology, and capital, for example, wouldn't lead to greater unemployment, as some claim. Rather, it would help workers to find jobs that add more value: for instance, jobs with distributors (delivering goods to retail outlets) and with intermediaries such as transport agents (delivering goods from manufacturers to wholesalers). Consumers would also benefit from better quality and lower prices. As reform spreads, other industries will experience similar outcomes.

Infrastructure. The government has invested in India's infrastructure and upgraded ports, telecommunications, and highways. But several important areas, such as power, water and sewerage, railways, and airports, remain troublesome, in part because intransigent state governments often block progress. Disputes over water-sharing rights, for instance, have slowed a $150 billion project that would link a number of India's rivers (the Brahmaputra, the Ganga, the Godavari, the Krishna, and the Yamuna) with a system of waterways. If completed, these canals would provide much-needed water to millions of Indians and boost agricultural productivity.

Meanwhile, the Electricity Act of 2003 aims to provide businesses with uninterrupted, low-cost power. The act permits the delicensing of power plants and provides for open access to generation, transmission, and distribution while phasing out cross-subsidies. So far, however, only eight state electricity boards have unbundled power generation, transmission, and distribution-a necessary step for implementing the measure. For this landmark effort, state regulators must also clarify myriad other details, such as the rules and access charges for third parties that supply industrial power and a clear definition of the contractual obligations of the generating companies. While these kinds of initiatives have failed to gain traction in the past, the central government has recently shown remarkable creativity in getting the states to play along.

Land reform. One of the greatest problems plaguing India today is confusion over land titles. Because of high stamp duties, property owners have long avoided registering transactions and instead transfer land through other means, such as powers of attorney. As a result, many titles do not correspond to the people actually in possession of the properties. Stamp duties must be reduced to international levels, and the government must streamline the registration system by establishing fast-track courts and implementing electronic record-keeping systems. Andhra Pradesh's progress in this area should encourage other states to follow its lead.

Urban renewal. Since India's independence, its urban population has grown fivefold, leading to overburdened facilities and greater numbers of urban poor. The central government has budgeted an initial $1 billion to finance its National Urban Renewal Mission, but states must also do their part. Measures that state governments ought to adopt include increasing usage charges such as property taxes and water and sewerage fees, improving collection rates for fees and taxes, enhancing the efficiency of municipal corporations, and making better use of assets in and around cities. In Mumbai, for instance, where terrible flooding recently underscored the need for quick progress, we estimate that the state could immediately finance about $10 billion in infrastructure improvements through measures such as reforming the property tax regime and improving collections from their current minimal levels. Public investments of this kind could attract an additional $40 billion in private funding. All told, these investments could greatly improve the quality of life for Mumbai's population.

Asset recovery. The government must continue to expedite the recovery of assets from bankrupt companies. To address the new market realities and to sustain the economy's long-term health, it should bolster recent measures that help lenders recover dishonored checks and assets from indebted companies. In particular, the government should clarify the mandate of the Asset Reconstruction Company of India, established recently by a consortium of banks, by giving the company a more active role in debt restructuring and recovery. Foreign institutions must also be allowed to invest in such ventures. Moreover, the government should encourage the sale of nonperforming loans by allowing foreign banks to purchase them and by making these transactions exempt from stamp duty.

Enforce measures protecting intellectual property. Over the past decade, the evolution of knowledge sectors such as pharmaceuticals, biotech, and IT services has been phenomenal. The patent law passed earlier this year will augment their growth. Now the government should enforce IP protection measures effectively and expeditiously; only then can India promote creativity and innovation and sustain its cultural, scientific, and technological development. To improve the protection of IP, India should also align its patent regime with global standards in order to prevent the sharing of proprietary information in areas such as data exclusivity and to improve the overall capacity and quality of the infrastructure and resources in the country's patent offices.

Labor reform. To increase exports of manufactured goods rapidly, the government must permit the free use of contract labor for all work and repeal a law forcing companies with more than 100 workers to obtain state approval before cutting jobs. In tandem, India's labor benefits should be extended to all workers, not just those in the organized sector.3 Reform legislation should also consider establishing safety nets and policies that ease the retraining of workers. Simplifying labor laws could unleash unprecedented levels of foreign direct investment and foster brisk growth in light-manufacturing industries, such as toys, leather, shoes, textiles, and apparel, where India's cost advantage and skilled workforce should help it become a strong global presence.

Privatization. In India as in other countries, selling state assets is controversial, but the government must build on its success in privatizing Indian Petrochemicals, Hindustan Zinc, Bharat Aluminium, and the international telecommunications service provider Videsh Sanchar Nigam, among others. To manage political opposition, the government might consider creating a trust or special-purpose vehicle to act as a holding entity, much as Singapore's Temasek does. After the assets have been transferred, the holding company could be taken public, effectively diluting the state's share in the companies (without privatizing them) and releasing them from statutes applying to the public sector. As long as these companies, representing 60 percent of the country's capital stock, remain in the state's hands, their full potential will not be realized. Proceeds from the sales could also be used to bring down the public deficit.

After more than four decades as a closed economy and 14 years of reform, India has ascended the world stage and laid the groundwork for rapid growth. Low interest rates have also provided a lift for the economy. If policy makers continue on the path of economic reform-with a focus on increasing demand and competition-the flow of foreign direct investment to India will most likely increase, helping it to harness the immense potential of its young and educated workers. The foundation is in place for the economy to grow by 10 percent a year, but further effort and unwavering commitment are needed for India to emerge as an undisputed global economic leader.

About the Authors
Ranjit Pandit is a director in McKinsey's Mumbai office.

Notes
1 The value-added-tax regime covers all manufactured goods and services, with proceeds shared between the central and state governments in a 68:32 ratio. The system is being implemented in three phases: the consolidation and unification of state taxes, the consolidation and unification of central taxes, and the equalization of tax rates for all manufactured goods and services.

2 Or approximately 14 percent on retail prices.

3 The organized sector essentially consists of companies that employ more than ten people.

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