Arvind Subramanian: India is converging, but why?

Policy reforms interacting with fundamentals explain Indian performance

Indian economic growth seems to have transitioned from a turnaround to a take-off phase. In the former, between1980 and 2002, economic growth averaged about 6 per cent a year. Since 2002, growth has soared to close to 9 per cent. In the medium run, the difference in living standards between the growth rates in the turnaround and take-off phases is staggering because of the "magic of compound interest," as Keynes put it. At 6 per cent growth, the standard of living of the average Indian increases four-fold over a generational span of 40 years. At 9 per cent, it increases sixteen-fold.

How special is India's recent performance? The International Monetary Fund's recent World Economic Outlook illustrates the dramatic improvement in economic performance across the developing world. Sub-Saharan Africa, which grew at just over 2 per cent during the 1990s, registered average growth of 5.5 per cent since 2003. Latin America's relatively anaemic growth rate of 3 per cent has similarly surged to over 5 per cent since 2004.

But looking at growth rates per se can be misleading. One metric for assessing performance is economic "convergence". If convergence is indeed at work, countries that are poorer to start with should be growing faster subsequently so that they can eventually catch up with, or converge to, the income level of the richest countries. Is this happening for the most recent period?

The middle chart plots per capita GDP growth for the period 2003-2006 against the level of per capita GDP in 2003. If convergence prevails, the line should be downward sloping (poorer the country, faster the growth). As the chart shows, this is not happening. Optimism about the poorest parts of the world is still premature.

But is India converging to the top league? The right chart plots the same variables "" growth rates against the level of income "" but this time for a sample restricted to the relatively affluent countries (upper and high middle income countries, and India and China.) Two things are noteworthy. First, convergence is evident in this sample, suggested by the downward sloping line. Second, and more importantly, India (shown as a triangle) is on the line, indicating that India is growing as rapidly as others have to join the club of rich countries.

But why is India converging and not others? This question also relates to explanations that have been offered for the recent growth acceleration in India.

The most plausible explanation, dubbed the "tipping point" hypothesis by Swaminathan Aiyar, argues that even though reforms have been modest in the recent past, the cumulative effects of all the reforms enacted over the last two decades have been substantial. Hence private investment has picked up substantially by about 7-8 percentage points of GDP within the short span of 4-5 years.

While appealing, especially in explaining the change in India's own performance over time, this explanation does not fare as well in a cross-country comparison. Judged against the yardstick of cumulative reforms, India is more laggard than leader. Most countries in Latin America, Africa, and Asia have gone faster and deeper in liberalising their trade, privatising their public sectors, opening up to capital flows, and deregulating their financial sectors. Why didn't these countries also "tip" over into Indian levels of private investment and growth?

Perhaps the puzzle appears so, only because of a basic problem in perspective. This perspective lures us into seeking the causes of fast-moving outcomes such as rapid economic growth in similarly fast-moving underlying processes or triggers such as policy reforms. But a richer perspective might well be one that allows for fast-moving processes to interact with long-acting and slower-moving ones (what might be called fundamentals) in determining long-run economic growth.

In the Indian case, the triggers were clearly the policy reforms initiated in the early 1980s, and reinforced after 1991, which have created a basic confidence in the private sector that the policy environment will be supportive rather than hostile. But there were slower-moving processes also at work (the fundamentals) that proved crucial to creating business opportunities for the private sector.

What were these fundamentals? Clearly, these vary over time and across countries, but for India three plausible candidates suggest themselves. First, the broad Nehruvian legacy of political investments that created the meta-institutions of democracy, the rule of law, independent judiciary, free press, and technocratic bureaucracy, all of which have been shown to be key to economic development. Commentators tend to deride Indian institutions as poor and deteriorating, which is probably true. But relative to India's current income levels they are actually very good, and good enough to sustain much higher levels of income.

A second fundamental was the investments in the IITs, IIMs, and the research institutes, which created over time, and with considerable lags, the pool of skilled and English-speaking human capital that are driving today's IT and economic boom.

A third was the creation, again over decades, of a large pool of managers and entrepreneurs, which has led to the "precocious India" phenomenon of a poor country exporting, uniquely, FDI to rich countries. How this pool came to be created merits serious examination but it is not inconsequential that at least some of today's successful managers and entrepreneurs cut their teeth in the old public sector and without competition from foreign direct investment.

Institutions, technological and managerial skills, and entrepreneurship are at the heart of the Indian growth acceleration today. And let it not be forgotten that each was the result of difficult public actions going back several decades. No doubt some of these actions entailed significant costs "" for example, in creating the licence-quota-permit raj-but it also helped foster private sector entrepreneurship and the conditions for it to flourish today.

The author is Senior Fellow, Peterson Institute for International Economics and Senior Research Professor, Johns Hopkins University