India is Converging, But Why?

Indian economic growth seems to have transitioned from a turnaround to a take-off phase (figure 1). In the former, between 1980 and 2002, economic growth averaged about 6 percent a year. Since 2002, growth has soared to close to 9 percent. 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 percent growth, the standard of living of the average Indian increases fourfold over a generational span of 40 years. At 9 percent, it increases sixteenfold.

Figure 1: Indian per capita GDP (log), 1960-2007
 
Source: World Development Indicators, World Bank.

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 percent during the 1990s registered average growth of 5.5 percent since 2003. Latin America's relatively anemic growth rate of 3 percent has similarly surged to over 5 percent 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?

Figure 2 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 figure 2 shows, this is not happening. Optimism about the poorest parts of the world is still premature.

Figure 2: (Lack of) convergence in the world since 2003
 
Source: World Development Indicators, World Bank.
Note: World sample of 164 countries.

But is India converging to the top league? Figure 3 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, 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.

Figure 3: India is converging
 
Source: World Development Indicators, World Bank.
Note: Sample of 53 upper-middle income and high income OECD countries, India, and China.

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 liberalizing their trade, privatizing 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 Indian Institutes of Technology (IITs), Indian Institutes of Management (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 information technology 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, foreign direct investment (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 FDI.

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 license-quota-permit raj-but it also helped foster private sector entrepreneurship and the conditions for it to flourish today.