History of India

How do we explain the fact that India is still one of the poorest countries in the world? Historically, India had great ancient civilizations—just like China—and for the last 60 years, it has been a stable and functioning democracy. So why is India such a latecomer when it comes to industrialization?

For most of its history, India was not a single country. Instead, it was a collection of many small independent kingdoms. I have explained why the Industrial Revolution occurred in the West earlier than in the East. After the Second World War, the rest of the world started the race to catch up. But, unlike Japan, South Korea, and Taiwan, which took the market/open economy approach, India and China took a socialist/autarky approach.

Even though India's government was not a Soviet-style totalitarian regime politically, economically it embraced a Soviet-style central planning system until the 1990s. It possessed all the features and weaknesses of a centrally planned economy, which put a heavy shackle on innovation and entrepreneurship. In the notorious “license Raj” system, to operate any business, an entrepreneur needed to obtain a license, which was often very costly and sometimes almost impossible. Furthermore, a law supposedly designed to help small businesses required special government approval for any business wanting to expand in size beyond a few hundred employees. There were many other onerous regulations that deterred Indian firms from growing larger. One of the laws required special approval to lay off workers for any business with more than a few hundred employees. So, if a business became successful and expanded, suddenly it could not fire anyone! For any business owner, it is a terrifying thought not to be able to fire any workers. (Not that we enjoy doing it, of course, but it is an essential tool in making certain that the business remains both productive and competitive.) As a result of these regulations, businesses in many industries stayed small, and many businesses had to resort to the illegal practice of hiring temporary workers, something not conducive to long-term growth.

This regime basically killed off incentives for innovation and entrepreneurship. The motive for being an entrepreneur or inventor is to create and grow a successful business and, hopefully, make a lot of money. When a firm cannot grow, smart people will find alternative employment. Also, restrictions on business size annihilate India's biggest advantage, which is the scale advantage of its huge market. I once compared the textile firms in China with the textile firms in India and found that the average firm size of Indian companies was much smaller than those in China. What compounds the problem is that the productivity of a firm strongly relates to the size of the firm. The largest textile firms were much more productive than the smaller firms. The large Chinese firms had tens of thousands of workers. The productivity of these Chinese firms was competitive even by global standards, and they were also large exporters as a result. In contrast, there is almost no large Indian textile firm. When I asked Indian business owners why they were unable or unwilling to expand, the answer was that the laws and regulations favored small enterprises, making it very costly to expand beyond a certain size. Consequently, unlike China, India does not have a large, labor-intensive, exporting manufacturing industry.

The other mistake that the Indian government made before the reforms of the 1990s was that it pursued a very restrictive trade policy rather than an open trade policy. This is partly because its firms could not grow bigger or compete on the global market. To protect its favored small businesses, the government imposed a heavy tariff on imported goods. Foreign direct investment into Indian companies was capped below 50%, which discouraged many multinational firms from investing in India. Like in many Latin American countries that tried to implement it, this important substitution policy failed miserably. Indian firms did not compete or interact extensively with other firms in the world, further slowing down their ability to keep abreast of developments, catch up, and innovate. Lastly, by cutting itself off from the global market, these restrictive trading policies slowed down the exchange of people, ideas, and technology with the rest of the world; another heavy blow to innovation and economic growth.

Prior to the reforms in the 1990s, the Indian economy grew on average only 3.9% from 1950 to 1990, compared with the Korean economy, which grew 9.6% on average from 1960 to 1990. After the Second World War, India's per capita income was roughly the same as that of South Korea, but by 1991, India's per capita income was only one-tenth that of South Korea. India was not the only place where ill-conceived economic policies did great damage. North Korea and pre-reform China performed even worse. The fact that post-reform China achieved spectacular double-digit growth in the 1980s was in stark contrast to the performance of the Indian economy before 1991.

In the early 1990s, after 10 years of watching China's rise as a result of its reforms, India launched its own reforms. But, with a functioning democracy, the pace of its reforms has been much slower than that of the reforms in China. It was not until an economist, Manmohan Singh, became the prime minister in 2004 that the pace of reform sped up. Under his helm, the “license Raj” system was mostly dismantled. Tariff and other trade barriers were reduced dramatically. Limits on foreign ownership were lifted in most industries. With the new economic policy, India's economic growth started to accelerate (Figure 10.2). The GDP growth rate has accelerated by an average 6–7% in recent years, and is projected to grow 8–9% over the next two to three years. Moreover, its exports and foreign reserves have also grown rapidly.

Is India's Growth Sustainable?

As argued in this book, human capital and market size are fundamental factors that drive innovation. India has been able to greatly expand its stock of human capital in recent years. The college enrollment rate has increased from 6% to 10% since the reforms in the 1990s. India now produces over 2 million college graduates a year. The quality of the college students must be relatively high, as India represents one of the largest sources of graduate students for the best U.S. graduate schools. The Indian Institute of Technology is a world-renowned university, graduating thousands of top students in engineering and science every year.

Leveraging its large human capital, India has developed a world-class IT outsourcing and service industry. IT service exports have grown from US$5 billion in 2000 to over US$20 billion in 2010 (Hyvonen and Wang, 2012). India's innovative index ranking is also ahead of most economies at the same level of per capita income. India's venture capital has grown from US$718 million in 2006 to US$4.4 billion in 2015 (Figure 10.3).

The Scale Advantage

With a population of 1.2 billion, India possesses an advantage of scale that is very much like that enjoyed by China. It has the second largest mobile phone and Internet market in the world, which allows India to develop indigenous Internet companies capable of competing head-on with multinational heavyweights (Figures 10.4 and 10.5). For example, Flipkart, an e-commerce giant, is leading the race against Amazon in India. Olacab, a taxi and car ordering company, is competing fiercely with Uber. The emergence of these home-grown Internet companies would not be possible in smaller countries.

However, India's metrics for innovation—such as research and development per capita and patents per capita—are still very low compared with high-income countries. This is because India is still mostly in the catch-up stage of development. At this stage, the main task is to adopt and adapt existing technologies, which also requires entrepreneurship and innovation, but does not require a huge amount of original research and development. For example, to meet the needs of India's poor, local phone maker Mircomax was able to lower the cost of its smartphones to about US$100; as a result, the company has become one of the top 10 mobile phone makers in the world. Ola, the local competitor to Uber, began offering rickshaw-ordering services in addition to its taxi-cab services, and is now bigger than Uber in India. A local version of Airbnb, Oyo Hotel, not only lists properties such as hotels, but also helps property owners to renovate and manage these. Makemytrip, the local competitor to Expedia, offers train and bus ticket services in addition to hotel and air ticket booking services. These are all examples of innovation in adapting technologies or business models to fit the local Indian market, and the speedy commercialization of these adaptions has been helped by India's colossal market size.

India's Infrastructure Problem

Many people worry that India's infrastructure is a bottleneck that is hampering economic growth. There is some truth to this, as India's infrastructure is indeed very poor, primarily due to insufficient investment. But all poor countries have poor infrastructure when they start to take off. As their economies grow, savings and investment rates will increase, and so will infrastructure spending. This is exactly what happened in China. In India, the savings rate has been climbing, along with the infrastructure investment (Figure 10.6). Anybody who has recently been to Delhi can clearly testify to the fact that the freeways and the airport are improving (Figure 10.7).

Export and Balance of Trade

The problem with many Latin American economies is that their exports are primarily commodities or natural resources. Whenever there is a slump in commodity prices, their balance of trade suffers and their currency value collapses, which often leads to financial crises and macro instability. India, on the other hand, has a growing export industry and a very competitive IT outsourcing industry. In recent years, the balance of trade has been improving (Figure 10.8). In 2007, it reached a record foreign reserve level of over US$200 billion.

Political System

Some people argue that democracy slows down with the development of a large country like India. This is partly true. When India adopted a market-based economy in 1991, it moved slowly, much slower than China. Only recently has it started to match China in terms of trade openness and ease of doing business, and only recently has it invested heavily in infrastructure, which is why India's growth rate is only now beginning to catch up with that of China.

But there is also a benefit in being slow and at the same time being responsive to voters. China's top-down government made a huge mistake in adopting the draconian one-child policy in the 1980s; further, its strong enforcement of the one-child policy made matters worse. With a tightly controlled press and top-down political process, only recently did the Chinese government realize its mistake and begin to relax the one-child policy. India, in the 1970s, also tried to control the population. Indira Gandhi even tried to implement forced sterilization for men with two or more children, but it proved to be unpopular and politically impossible to implement in a democratic society. Today, India's growing and young population is widely regarded as an asset rather than a burden, so in hindsight, India avoided an absolutely critical policy error precisely because of its democratic political system.

Poverty and Inequality

With a rapidly growing economy, inequality usually rises, because the income of those who are very successful (such as entrepreneurs or IT engineers) grows more quickly than that of the rest of the working population. This is actually healthy, as high rewards for success induce people to work hard and take risks. Before the reform, the highest marginal income tax rate was as high as 80% in India; this punishingly high tax rate guaranteed that everybody would be equal, but equally poor. Now the top marginal income tax rate is 40%. There will be some super-rich individuals, but the rising tide will lift all boats. As its economy has expanded and continues to expand, India has lifted hundreds of millions of people out of poverty. In the future, there will be hundreds of millions of people moving into the middle class. India has a system whereby people are judged by their caste, but with more people in the middle class, even the caste system is fading as people are primarily judged by their education, job, and income instead.

Brain Drain or Brain Gain?

Some people argue that although India's universities produce excellent engineers and researchers, many of them move to the United States following their graduation, leading to a brain drain out of India. Every year there are about 100,000 college graduates going abroad to work and study, but this represents only about 0.5% of the total annual graduating cohort. One half of a single percentage point is not a significant dent in the overall pool of human talent in India; rather, this 0.5% is potentially a “brain gain.” As soon as the Chinese economy started to take off, many members of the diaspora started to return to their home country, bringing with them all their education, experience, and the capital they had gained overseas. It is estimated that approximately 50% of the Chinese diaspora has now returned to China. Moreover, those who do not return can also help their home country in many ways. Many multinationals are setting up research and development facilities in India and China, partly because their executives are originally from India or China. Executives of Indian descent are highly successful in multinational firms. The current CEOs of Google and Microsoft, for example, are Indian immigrants to the United States, and these multinational firms are likely to continue to expand their presence and research/development activities in India.

Natural Resources

Just like China, India will consume a large amount of natural resources and energy as it industrializes. As I demonstrated in Chapter 4, there is, globally, a sufficient amount of resources to sustain a world population of 10 billion. In terms of agriculture, even though India has a population of over 1.2 billion people, after the Green Revolution to adopt modern agricultural technologies, it actually has more food than it needs, and has become a major exporter in the world food market.

India is a major importer of oil and has benefited greatly from low oil prices. I predicted earlier in this book that due to innovations in shale gas, solar, and battery technologies, oil and energy supply generally will continue to be abundant, and this is very good news for India's economy. On the demand side, China has already moved into the next stage of development to focus on developing its service and high-end manufacturing industries, and its appetite for energy and resources will likely slow down in the near future. This slump in demand will also help to keep prices down—and this is just what India needs as it industrializes.

The Environment

There is some bad news here; India's environment will get worse before it gets better. The general pattern is that a country's environment will improve after it reaches a per capita income of US$8,000–10,000, at which point the country will have both the means and the will to improve its environment. In the case of India, it may not need to reach this US$8,000, because the technology for eliminating and controlling pollution will be cheaper and more advanced in the future, driven by developments in other countries. But in the short run, India's environment will certainly get worse, unfortunately much worse than it is today. It will, however, improve when India reaches the next stage of development.

Future Economic Outlook

India certainly has all the ingredients for a high-income country: a stable government, an open and free market, high-quality education, a growing export industry, and most importantly a young and growing population. Obviously, China also has these very same ingredients, including (still) a growing and young population; however, very soon it will have a shrinking and aging population. In this light, India's economy may have the chance to get the upper hand over China in the long run.

Let us compare the population age structure between India and China.

Compared with India, the population problem facing China becomes quite obvious (see Figures 10.10 and 10.11). India has an almost perfect population pyramid today. Its median age is 28, compared with a median age of 38 in China. The fertility rate in India is around 2.4, compared with China's 1.3 (i.e. almost 70% higher). The number of newborn babies in India is about 22 million today, compared with only 16 million in China. This means that today, the number of newborn babies in India is 40% higher than in China; further, as a result of continuing declines in the fertility rate in China, it is estimated to be 60% higher in about 10 years' time.

When India reaches the middle-income level by 2040, it will have the largest population and the largest scale advantage in the world. India also has the advantage of being an English-speaking country. Compared with China, India's companies will have an easier time accessing the global market and operating around the world. Its academic community will have an easier time integrating with the rest of the world. In addition, India will be able to attract more immigrants than China, because of their ability to speak English.

By 2040, India will still be growing faster than China, further closing the gap between the two countries in terms of per capita GDP. At the same time, India's fertility rate will continue to be significantly higher than that of China. As a result, by 2080, India will have a population of 1.6 billion, 30% larger than the projected population of China (1.2 billion). India will also have a working-age population of 0.8 billion compared with China's 0.5 billion. This is almost 60% higher than the working population of China. So, even if India achieves only two-thirds of the labor productivity of China, India's economy will be larger than that of China, and much bigger than that of the United States.

If we look at the number of young workers in the longer run, then by 2080 India will have more than 0.4 billion workers between the ages of 20 and 39, twice as many as China (Figure 10.12). I have previously argued that young workers are the most creative and entrepreneurial part of the work force. Not only will India have a larger young cohort, but also the future Indians will likely be more innovative and entrepreneurial than their young Chinese equivalents, who will be handicapped by the blocking effect of an aging economy, something we have discussed in detail in this book. It is therefore very likely that by the late twenty-first century, India will be more innovative than China.

In summary, China will be the largest economy after 2025, surpassing the United States; however, in less than 60 years, India will take over as the largest economy in the world. The demography of each country is the main driver behind the dynamics of the relative strength of these three leading economies.

Other Developing Countries

India will certainly not be the only poor country capable of moving to the middle-income level over the next 20 years. Many poor countries, such as Burma and Vietnam, will also catch up. With the appropriate economic policies, these countries could grow quite rapidly and reach the middle-income level (close to US$10,000) in two generations.

Nevertheless, I believe (everything being equal) that such small countries will necessarily grow more slowly than their larger rivals. For example, while India can grow by 7% a year (everything being equal), smaller countries can only achieve a maximum growth of 5–6% a year. The reason for this is simple. The quantity and quality of human capital and the size of the domestic market do not favor growth in these small countries in the same way as they do in India; consequently, innovation and entrepreneurship are likely to be less vibrant. At the catch-up stage, what's important is not frontier innovation, but the absorption and adaption of technologies already invented by high-income countries. With a small market and a limited stock of human capital, the absorption and adoption process will necessarily be slower. A 1–2% difference in growth rate is quite significant over the long term. Mathematically, a 1.5% difference a year would add up to 34% over 20 years. At 7% a year, it would take about 20 years to quadruple the size of the economy, whereas at 5.5% a year, it would take a smaller country 25 years to quadruple the size of its economy.

One might say that an additional five years required in order to reach the middle-income level is not a significant difference, but the size advantage matters more after a country reaches the middle-income level. Increasingly, the size of the home market and the concentration of the talent pool are key ingredients in becoming a center of innovation, especially when it comes to frontier innovations. Other developing countries, with a low stock of human capital (both in terms of quantity and quality) and a smaller market size, will be no match for the three heavyweights: India, China, and the United States. It will be tough for smaller newcomers to compete. Korea, with its very high quality of human capital and relatively large size, has a chance to join the wealthy club, but Taiwan, with only half the size of Korea, is having a tough time becoming an innovation center. It is increasingly difficult for Taiwan to reach a critical mass of talent for any important industry, despite having a very high quality of human capital. Taiwan's talented young people are moving to larger innovation centers in the United States or China; its ultra-low fertility rate is not helping matters either.

Of course, many of these smaller countries are very nice places to live in or visit. For example, while Taiwan's economy is not as robust as that of Korea or China, its lifestyle is more relaxed and the quality of life is comparatively very good. However, these countries will take a back seat in the innovation and economic progress of the human race.