Why India lags behind China - vox

voxeu.org (http://www.voxeu.org/article/why-india-lags-behind-china)
What India must do to modernise
Arvind Panagariya, 15 January 2008
Historically, successful development has involved exporting labour-intensive
manufactures. Despite opening up to the world economy in many respects,
Indias policies continue to retard the expansion of labour-intensive sectors.
Here is a discussion of how India could speed its transition to a modern
economy.
a
A
A key advantage claimed for the outward-oriented development strategy is that
it allows poor, labour-abundant countries to specialise in labour-intensive
products and, thus make efficient use of limited capital stocks. To quote Anne O.
Kruger (1985), An export-oriented strategy permits countries to use the
international market to exchange their own, relatively labour-intensive
commodities for capital-intensive goods. They are thus able to take advantage of
the division of labour and specialisation. This ability contrasts sharply with
import-substitution policies under which labour-abundant developing countries
produce the entire spectrum of manufacturing goods and experience high and
rising capital/labour ratios.
The experiences of South Korea, Taiwan, Brazil and most recently China offer
broad support to this claim. Increasing shares of industry in GDP in general and
of labour-intensive manufactures in particular accompanied the adoption of
outward-oriented strategies in these countries. Exports of unskilled-labour-
intensive products such as apparel, footwear, toys and numerous light
manufactures expanded rapidly.
Indias recent engagement with the world economy has produced a contrasting
pattern, however. Contrary to the impression in many circles, Indias industrial
and services sectors are almost as open as those of China. The simple average of
industrial tariffs is 12% compared with 9% in China. The highest industrial tariff
rate (with tariff peaks in several sectors) has been brought down to 10%. In fiscal
year 2005-06, custom duty as a proportion of merchandise imports was just
4.9%. With some negative-list exceptionsmost notably multi-product retail
the goods and services sectors are quite open to foreign investment. Only in
exceptional cases such as insurance and media the sectoral cap on foreign
1
investment caps are below 51% and in most cases go up to 100%. While this
opening-up has been accompanied by acceleration in growth to 6.3% during the
last two decades and to almost 9% in the last four years, Indias experience
differs from that of China in at least three important respects. First, while India
has seen the share of agriculture in the GDP decline, it has not experienced
perceptible rise in the share of manufactures. Second, exports out of and direct
foreign investment (DFI) into India have not seen the same rapid expansion as
that seen in the case of China. Finally, fast-growing exports from India have been
either capital-intensive or skilled-labour intensive. The shift in favour of
unskilled-labour-intensive products traditionally observed in response to the
adoption of outward-oriented polices has not happened in India.
Indian exceptions
The share of manufacturing in the GDP in India has been stagnant at 17% since
the early 1990s. In China, this share stood at a hefty 41% in 2006. Indias
leading and fast-growing exports, such as engineering goods, petroleum
products, gems and jewelry, and software, are either capital-intensive or skilled-
labour intensive. The share of textiles and textile products in total merchandise
exports has declined to 15% in 2005-06 from 20% in 2003-04. Within this
category, unskilled-labour-intensive ready-made garments account for only half
of the exports. In contrast, the export pattern of China quickly adjusted to its
factor endowments after it began opening up its economy in the late 1970s and
early 1980s. First, exports of textiles, apparel, toys, sports goods and footwear
surged. Then in the 2000s, with rising skill endowments, it moved into more
sophisticated assembly operations such as office machinery,
telecommunications and electrical machinery.
The most dramatic difference between India and China lies in the magnitude of
international economic engagement. One measure of this difference is that the
annual expansion in Chinas trade has been larger than Indias total annual trade
during last several years. For instance, Chinas merchandise exports expanded
by $169 billion to $762 billion in 2005 in comparison to Indias total
merchandise exports of $103 billion in 2005-06. Equally dramatic are Figures 1
and 2 with the former showing the evolution of China and Indias two largest
merchandise exports and the latter depicting DFI inflows.
2

What holds back India?
How do we explain these differences in the response to trade openness of two
economies with very similar factor endowments? The key to answering this
question is the poor response of large-scale labour-intensive manufacturing
including assembly and processing activities in India. As per the conventional
wisdom, these activities have served as the magnet for DFI and a conduit for
rapid expansion of exports in China. But this has not happened in India. Large-
scale labour-intensive manufacturing activities have been virtually absent from
India. Apparel factories employing thousands of workers under a single roof
found in China are non-existent in India.
The explanation for the poor performance of large-scale labour-intensive
manufacturing is, in turn, to be found in the domestic policy regimeboth past
and present. Until the late 1980s, large Indian firms were confined to a positive
list of capital-intensive sectors. Even in these sectors, their size was limited
through licensing based on the perceived size of the domestic market by the
authorities. The same applied to foreign companies. These restrictions were
largely ended by the mega reforms of 1991 and those that immediately followed
them.
But this was insufficient to stimulate large-scale labour-intensive manufacturing.
In the late 1960s, India had also adopted the policy of reserving labour-intensive
manufactures for the exclusive production by small-scale enterprises. Even after
years of steady relaxation, the small-scale enterprises face a ceiling of 50 million
rupees (approximately $1.25 million) on investment in plant and machinery.
The small-scale industry list grew over time and by the late 1980s came to
include virtually all labour-intensive products.
As long as this reservation was in force, high-quality labour-intensive
manufactures that could compete on the world markets had no chance of
emerging in vast volumes. The bulk of the small-scale enterprises operated in
the protected domestic market. The problem was finally recognized in the late
1990s and the government began to gradually trim the Small Scale Industy list.
Even then progress was slow and the number of reserved items fell from 821 in
1998-99 to 114 in March 2007.
Most labour-intensive products including toys, footwear, sports goods and
apparel have now been off the reservation list for some years. More importantly,
even for products still on the list, large-scale production has been permitted
since at least March 2000 as long as the enterprise exports 50% or more of its
output. This latter change means that firms predominantly interested in
exporting their output have been free of such restrictions since March 2000. Yet,
labour-intensive manufacturing has remained stubbornly unresponsive.
The most important factor that still holds back large firms from entering these
products is a set of draconian labour laws in India. Under these laws, it is
virtually impossible for a firm with 100 or more employees to fire the workers
even in the face of bankruptcy. It is equally difficult for the firms to reassign the
workers from one task to another. These provisions impose very low worker
productivity or a high real cost of labour. Large-scale capital-intensive sectors
such as automobiles, where labour costs are a tiny proportion of the total costs,
can profitably operate in such an environment. But the same is not true of large-
scale labour-intensive sectors labour. Few foreign manufacturers are willing to
enter India outside of a small subset of capital- and skilled-labour intensive
sectors.
Two additional factors have held back the labour-intensive manufacturing in
India: costly power and poor transport infrastructure. Not only do firms pay a
much higher price for power in India than elsewhere in the world, they also face
much greater uncertainty of supply. Likewise, despite considerable
improvement, the transportation network in India remains unreliable and
inefficient. The time taken to clear the goods entering and existing the ports and
to move the goods between ports and manufacturing sites, which is so critical for
assembly and processing activities, is much higher and more variable in India
than in the competing countries such as China.
Indias path to modernisation
While high growth has helped India bring its poverty ratio (the proportion of the
poor below the official poverty line) down from 36% in 1993-94 to 27% in
2004-05, its transition to a modern economy remains problematic: it must still
move the vast majority of its workforce out of farming into non-farming
activities. With the services leg doing all of the walking, the economy can only
limp along towards this transition. For a more rapid transformation, India must
walk on two legs. That means more rapid growth of the labour-intensive
manufacturing.
References
Krueger, Anne O. 1985. The Experience and Lessons of Asias Super
Exporters, in Vittotio Corbo, Anne O. Krueger, and Fernando Ossa, editors,
Export Oriented Development Strategies, Boulder and London: Westview Press.
Panagariya, Arvind. 2008. India: The Emerging Giant, New York: Oxford
University Press.
Prasad, Eswar and Shang-Jin Wei. (2006). Understanding the Structure of Cross
border Capital Flows: The Case of China, presented at the conference, China
at Crossroads: FX and Capital Markets Policies for the Coming Decade, held at
the Columbia University on February 2-3, 2006.
Footnotes