Glimpses from India’s Financial History
As we look around the world today, much of it is not recognizable any more. Looking at economic data now is a bit like looking at a car pile-up, deeply upsetting yet difficult to ignore. I also believe that traditional economic metrics can be very misleading during times of crisis. How then do you think about the future? At times like this I am reminded of an interview of Ray Dalio, that I happen to remember very vividly. Ray studied almost two centuries of economic history and came to a conclusion that the single biggest driver of growth over time has been the human pursuit for improvement. We must count on this essential human spirit to think about the future with optimism and hope.
But to think about where we are headed, we must first make sense of where we have been. In this article we will do a survey of India growth trajectory over the years and try to understand what has worked for India and why. I have broken up this last 70-year period into a few phases:
Phase 1: 1950–1970
During this time India’s GDP growth rate averaged at about 3.5% per anum. This may seem low in today’s context but it is important to remember that India’s growth in the first half of the 19th century was barely 0.9%. India’s growth was lower than the growth rate of many south Asian peers, most notably Korea and Taiwan but also less successful countries such as Pakistan. This earned India the moniker of ‘Hindu rate of growth’ but it belies more structural and fundamental reforms that India undertook at the time. India also had to bear the economic burden of partition and wars with both Pakistan and China. Arguably India’s biggest economic gamble at the time was to steadfastly stick to its democratic model as outlined in the constitution, even though the federal structure was not strictly followed in the early years. The next major reform undertaken by India was the Zamindari Abolition Act, that broke the feudal structure of Indian society and gave economic rights to millions of small and marginalized farmers. Jawaharlal Nehru’s inward-looking approach, led to the development of India’s first large scale industrial projects starting with the Power and Steel sector. However, the License Raj instituted under the second Five-year plan (1956–1961), stifled the private sector and hindered growth in the manufacturing sector. The shift of capital towards the government sector, combined with wars (1962 Indo-China war and 1965 Indo-Pak war) led to a significant reallocation of resources from the agricultural sector. This combined with weak monsoons in the 1965–1967 led to a sharp rise in inflation. It is in this backdrop that India undertook Green Revolution, under the leadership of Lal Bahadur Shastri. This led to a sharp improvement in India’s food grain production and permanently ended India’s repeated encounters with famines. This was shortly followed by ‘Operation Flood’, that led India to self-sufficiency in milk production. This simultaneously added a second source of income to Indian farmers and helped India tackle child mal-nourishment.
Phase II: 1970–1990
By the time we entered 1970, Indira Gandhi had been prime minister for 4 years and have had to make some concessions such as devaluation of the rupee in 1966 and some liberalization in trade policy to manage the balance of payment crisis. Many commentators at the time who believed that democracy was premature for India were initially vindicated by the growth rate of India in the early part of 1970s. Post the major nationalizations of the banking and insurance sector that were carried out in 1970 and 1972 respectively, growth almost reached 9% just as India was headed into emergency. But hidden in this headline number was the sorry state of the Indian private sector. Acts like Monopolies & Restrictive Trade Practices Act and strict import and export control significantly stifled the private sector. Perhaps an unintended consequence of the nationalization of banks, was that the savings rate of the country improved because banks were given a diktat to open more branches in rural parts of the country. This is evident from the data shared above.
Indira Gandhi came back to power in 1980 but was significantly more liberal in her economic thinking and initiated some economic reforms. The first major reform was the de-regulation of the cement industry in 1982. Rajiv Gandhi carried this reformist approach forward. For the first time the 1985 Budget brought down direct tax of companies and reduced the effective income tax for individuals. He also started unwinding the trade incense system by curtailing the powers of the MRTP Act and broadening the definition of products to allow businesses to expand in adjacent categories. The government thrust on the Telecom sector followed by relaxations in the foreign exchange restrictions led to the IT boom in India. Growth in the last few years of 1980’s almost reached 10%.
Phase III: 1990 onwards
More than the actual reforms, the 1980s for the first time marked a change in the attitude in the government machinery. Instead of creating plans and restrictions, the government started reposing greater trust in the market. However confidence ran ahead of actual change in the economy and much of the growth was driven by high borrowing at both government and firm level. The piper came calling in 1991, when a combination of oil shock and capital outflows led to a balance of payment crisis.
The government of the time under the leadership of PV Narasimha Rao and Dr Manmohan Singh used the crisis to pursue wide ranging economic reforms. The magnitude of these changes was so large and their positive impact was so evident, that it was difficult for subsequent government to unwind these changes. Much has been written about India’s economic resurgence in the 1990s post this episode so I may not be able to add much to that body of work. Instead I thought in this note we would instead look at what really changed in India at the level of factors of production.
The basic Solow Model essentially deconstructs the growth of the economy into a few factors:
1. Labour: This typically accounts for the productive labour force of the economy.
2. Capital: Capital is the sum of private plus public capital that is put to use in an economy.
3. Total Productivity Factor: The residual factor in growth accounting which generally points towards the productivity with which all factors are being used
I will be quoting extensively from a study conducted by Bosworth and Collins (2014). The great thing about this study is that they have essentially further decomposed the traditional Solow model to include the effect of Land and Education. The benefit of including land in this analysis is that this makes it possible for us to understand the impact of pure monetary capital in the agricultural sector. Similarly education is seen as a growing component of human capital, especially for a young country that is rapidly educating itself.
A few things are evident from this table. India’s growth trajectory has permanently changed post 1980, with productivity gains driving much of the incremental growth. This trend is also evident by looking at the sector level growth decomposition:
1. In Agriculture the growth has been driven by an increase in capital and an increase in productivity. Post bank-nationalisation the share of credit going to agriculture has increased steadily and that has enabled farmers to pursue productive agents like fertilisers and also farm machinery.
2. In industry the TPF increase has been the sharpest and accounts for all the delta between the 1960–1980 period and the 1980–2000 period. This is a clear effect of the unshackling of the private enterprise and a reduction in the role of the government. However, the slow growth in capital/worker is a bit disappointing and is in contrast with evidence from other south Asian countries.
3. The services sector is the most starling aspect about Indian economy. Typically, high value services start growing at a much later stage in the development cycle. The services setor in India is a combination of both traditional (healthcare, trade) and high value services (finance, business services) and both of these have seen sharp growth aided by TPF.
The other way to understand overall economic growth is to view it from the lens of industry re-allocations. A potentially important source of growth comes from the reallocation of resources from less productive to more productive activities. Since Valued Added per worked is about 4 to 5 times higher in industry and services than agriculture, it makes sense to shift factors from agriculture and thus generate higher growth and income. We understand the contribution of re-allocation by studying the difference between weighted sectoral growth and the actual growth in output per worker. Until 1980, when India was a controlled economy this was only 0.4% but has subsequently grown to 1% between 1980 to 2010.
Going back to the point Ray Dalio made about the essential and most durable driver of economic growth: our drive for betterment and efficiency. Or in economic parlance TPF, the residual factor of growth that’s not explained by labor or capital. Evidence from the last few decades show that this essential spirit of the Indian economy has been unleashed and I’m certain that this will carry us for much longer.
1. Acharya, S., I. Ahluwalia, K. L. Krishna, and I. Patnaik. 2006. Economic Growth in India, 1950–2000. In K. S. Parikh, ed. Explaining Growth. New Delhi: Oxford University Press.
2. Basu, S. and J. G. Fernald. 2009. What Do We Know (and Not Know) About Potential Growth? Federal Reserve Bank of St. Louis Review. 91 (4). pp. 187–213.
3. Bosworth, B., S. Collins, and A. Virmani. 2006. Sources of Growth in the Indian Economy. India Policy Forum, Global Economy and Development Program. The Brookings Institution.
4. Bosworth, B., and S. M. Collins. 2008. “Accounting for growth: comparing China and India.” The Journal of Economic Perspectives
5. Eichengreen, B., and P. Gupta. 2011. “The service sector as India’s road to economic growth.” National Bureau of Economic Research Working Paper 16757, National Bureau of Economic Research, Cambridge, MA.
6. Hsieh, C. T., and P. J. Klenow. 2009. “Misallocation and manufacturing TFP in China and India.” The Quarterly Journal of Economics
7. Kumar, U., and A. Subramanian. 2011. “India’s Growth in the 2000s: Four Facts.” Peterson Institute Working Paper Series 11–17, Peterson Institute, Washington, DC.
8. Rodrick, D and Subramaniam, A 2004. ” From “Hindu Growth” to Productivity Surge: The Mystery of the Indian Growth Transition” NBER Working Paper №10376
9. Basu, K., and A. Maertens (2008). ‘The Pattern and Causes of Economic Growth in India’. Oxford Review of Economic Policy, 23(2):