Securing India’s place in the global economy

GDP growth is soaring, and India’s economic reforms are bearing

fruit. But there’s much left to do.

Adil S. Zainulbhai

Web exclusive, October 2007

India is moving quickly to capture its place on the world stage. Just
16 years after embarking on the path of economic reform, the
country has freed itself from the slow growth that plagued it during
the decades after independence; in the past fiscal year1 GDP growth
reached a robust 9.4 percent. India’s best companies are targeting
global markets, as Tata Steel’s $11 billion takeover of its Anglo-Dutch
rival Corus shows, and the Indian consumer is attracting worldwide
attention. But to sustain these advances, the country cannot rest. Its
leaders must focus on building infrastructure and developing a
thriving labor market.

The economic reforms that began in 1991 marked a turning point in

India’s economic history. Under the program, the country successfully
laid the foundation for robust economic growth by transforming itself
from an agrarian, underdeveloped, and closed economy into an open
and progressive one that encourages more foreign investment and
draws more wealth from services and industry. Real GDP growth
averaged 8.6 percent over the past four years, and the country’s
economic planners expect it to grow by an average of 9 percent a
year through 2012. India boasts companies with world-class
capabilities in sectors such as automotive, information technology,
manufacturing, and pharmaceuticals. Net capital inflows2 topped $46
billion in fiscal 2006–07, compared with only some $24 billion a year
earlier.

Since 1985 India has lifted more than 100 million people out of
desperate poverty in urban centers and the hinterland alike

Most important, the benefits of reform have reached a broad

constituency. Since 1985 India has lifted more than 100 million
people out of desperate poverty in urban centers and the hinterland
alike, according to research by the McKinsey Global Institute (MGI).3
India’s population grew by 352 million during this period, and 431
million fewer people live in desperate poverty today than would have
if it had remained at the 1985 level. Looking forward, MGI estimates
that if GDP grows by a modest 7.3 percent a year over the next two
decades, the country’s poorest people will continue to gain ground, so
that the deprived segment—those making less than 90,000 rupees
annually, about a dollar per person a day—will drop from 54 percent
of the population in 2005 to 22 percent by 2025.

Yet India can’t afford to rest on its laurels. Sustaining inclusive

economic growth will require the country to focus on improving its
infrastructure, both hard and soft, and on creating a thriving labor
market. To accomplish these goals, a series of economic and social
reforms will be needed.

The hard and soft infrastructure challenge

India’s need for a better infrastructure is evident. The inadequacy of

the present hard infrastructure is manifested in the country’s poor
and insufficient roads, its crippling electric-power deficit, the shortage
of rail freight corridors, the poor ports, the bursting cities, and the
overcrowded and stiflingly hot airports. As for the soft infrastructure,
such as schools and hospitals, discouraging infant mortality rates and
alarming levels of illiteracy are just two symptoms of its gross
shortfalls. The hard and soft infrastructure alike must improve at an
even faster pace than they are today.

Cement and steel

India’s hard infrastructure hasn’t kept pace with economic

developments. From 1998 to 2005, annual investments in it averaged
4 percent of real GDP, compared with 8.2 percent in China, which
invested early and heavily to build a world-class infrastructure that
can attract foreign money and spur economic growth. In contrast,
India’s infrastructure investments have taken off only recently,
reaching about 4.7 percent of GDP, or $34 billion, in fiscal 2005–06.
Current plans call for an additional $475 billion4 in infrastructure
investments over the next five years, with a significant share
privately funded.

The government should be applauded for its greater pragmatism

about public-private partnerships and its willingness to take on
ambitious efforts, such as Bharat Nirman (a rural-development
program) and the privatization of the Mumbai and New Delhi airports.
Infrastructure deficits in urban areas, roads, ports, and power are
being addressed as well. Yet these measures, taken as a whole,
hardly suffice.
To improve the infrastructure significantly on a nationwide scale, the
government will also have to undertake systemic reforms. Immediate
action is needed in a number of areas: land market barriers (unclear
land titles and insufficient databases, for instance); inadequate long-
term financial instruments to meet the equity and debt needs of large
infrastructure projects; weak policies and regulations, stemming from
coalition politics, that are subject to frequent change; and unrelenting
red tape at the lower levels of central and state governments and
other authorities.

Further, among other things, state governments must repeal the

Urban Land Ceiling Act (which restricts the amount of land available
for housing), resolve unclear land titles by creating fast-track courts,
computerize land records, raise property taxes, and change the
tenancy laws. To improve India’s crippling electric-power deficit and
reverse its adverse impact on business, the government will have to
secure payment guarantees for private power generators, establish a
power exchange, and push for the partial or complete privatization of
power distribution.

Minds and bodies

India is expected to become the world’s most populous country by

2035. It’s already the youngest: one-fifth of the world’s population
under 24 years of age lives there. While this kind of population
growth represents a huge opportunity, it also highlights the need to
invest substantially in human-resources development, particularly in
education and health care, and to create adequate employment
opportunities.

Building the institutional ability to ensure the timely and equitable

delivery of such services will be vital for equitable growth. What’s
more, the huge and pressing demand for soft infrastructure can’t be
addressed by the government, private enterprise, or the community
acting alone. Only when all parties work together can these needs be
satisfied.

Education. India has the world’s largest school-age population. If

these children had access to a quality education, they could drive the
innovation, productivity, and development needed to ensure India’s
continued growth. Unfortunately, however, India’s educational
attainment remains poor compared with that of other nations,
including China: only 60 percent of Indians are literate, compared
with 90 percent of Chinese. Reforms designed to improve literacy
rates must begin at the elementary-school level. Experience around
the world suggests that a good primary education in rural areas is
critical. By and large, India’s state governments have failed to provide
quality education to these students.

Another key issue plaguing India’s educational system is a dearth of

qualified teachers, since research suggests that they are crucial for
improving results. The country’s average student-teacher ratio is
estimated at 37, potentially in line with the World Bank’s
recommended norms. But more than a third of the children attend
schools with significantly worse ratios, and more than half of the
schoolteachers haven’t completed secondary school.

In higher education, India must increase the number of openings

substantially and improve the quality of instruction. To stimulate
private-sector investment in colleges and universities, the
government might create pilot focused-education zones, where
educational institutes could be set up with complete autonomy in
admissions, fees, course offerings, faculty recruitment, and delivery
and evaluation methodologies. The zones could be open to foreign
universities and to for-profit entities that would offer regular degree
courses, with the entry and exit of players determined by market
forces.

India must produce more graduates with the skills needed for
employment in the global economy. Lifting literacy rates will be vital
to shift a growing populace from agriculture to high-value economic
activity not only in high-tech services but also in manufacturing. Even
in the former, where India is often thought to have abundant talent,
our research suggests that there may be a shortfall of about 500,000
qualified candidates by 2010. Part of the solution for generating a
greater volume of qualified jobseekers must be public-private
partnerships that strengthen industrial-training institutes and more
vocational programs tailored to the needs of various industries.

Health care. Altogether, India produces roughly 400 public-health

professionals a year, about as many as a couple of public-health
schools in the United States might. Yet two million to three million
Indians are infected with HIV/AIDS—accounting for the world’s third-
largest infected population. The country’s infant-mortality rate is
more than twice that of China, which also boasts a substantially
longer life expectancy. Clean water and sanitation remain out of reach
for many people in India; the emergence of lifestyle diseases (such as
obesity and diabetes) and the increased level of systemic health
burdens are worrisome too. Yet public spending on health care is less
than 1 percent of GDP. This situation must change quickly, and the
central government plans to increase spending to 2 to 3 percent of
GDP by 2012.

McKinsey research suggests that during the next ten years India will
need more than 10,000 public-health professionals to supply
preventive health services. These experts will also be needed to train
500,000 volunteers, whom the government intends to place in
villages throughout India as part of the National Rural Health Mission,
and to shape the response to myriad public-health policy issues
through meaningful research and advocacy.

What’s more, to have a strong and healthy workforce, India must act
urgently to increase the number and reach of its effective public-
health services. The Public Health Foundation of India, a public-
private partnership established to produce 10,000 qualified public-
health workers over the next few years, is one effort to bridge the
gap between the need for and the supply of skilled service providers.

Developing a thriving labor market

India’s huge and growing population—of somewhat more than a

billion—could be considered one of the country’s biggest assets,
representing an almost limitless labor supply and consumer demand.
Yet this mass of people could become one of the greatest forces
against reform if they can’t find jobs; in 2003, for instance, the labor
force grew by 12 million, but employment in the organized private
sector fell by 200,000. India absolutely must create a thriving labor
market not only to shift workers from agriculture to higher-value-
added activities but also to absorb a growing workforce and sustain
social equilibrium.

A critical step would be the systematic deregulation of sectors such as

retailing, defense, the news media, and banking, which remain
crippled by archaic policies. With deregulation and the opening of
markets, vital foreign direct investments of capital and skills could
flow more readily into India, making its industry more effective.
Coupled with low interest rates, such an influx of foreign capital
would help sustain the economy’s buoyancy.

In addition, reforms are needed in the coal, power, and natural-

resources industries to increase competitiveness, foster the creation
of higher-value jobs, and support economic growth. Continued
privatization of state-owned enterprises must also remain a focus for
the government.
Private-sector nonagricultural employment has stagnated at below 9
million for the past 20 years, though the labor force now exceeds 400
million people

Beyond general deregulation and liberalization, India must repeal its

complex and rigid labor laws, which discourage the creation of jobs
by offering excessively stringent protections for people who work in
the organized part of the economy. According to the World Bank,
India’s level of private-sector nonagricultural employment has
stagnated at below 9 million for the past 20 years, though the labor
force expanded to more than 400 million people during that period.
Removing the rigidities will allow India to harness the potential of its
growing workforce. That is especially critical for the manufacturing
sector and for creating opportunities in rural areas.

Augmenting manufacturing growth

India can no longer expect to outperform its competitors unless

manufacturing grows substantially. Its high-tech industry has rightly
won fame, and it can look forward to tens of thousands of new jobs
emerging if, as expected, revenues from the business-process-
outsourcing and IT industries triple by 2010, to at least $60 billion.
However, these sectors will never provide the number of jobs needed
for all of the tens of millions of Indians seeking opportunities.

If India were to leverage its inherent strengths in skill-intensive

manufacturing, exports could surge to about $300 billion, creating 25
million to 30 million jobs by 2015. Emphasizing apparel, auto
components, electrical and electronic products, and specialty
chemicals could help “Made in India” to become the next big
manufacturing-exports story. But achieving this goal will require
action on a number of fronts.

The first step will be to ignite domestic demand, which would help
attract multinational manufacturers and provide the scale needed to
be globally competitive. To this end, the government should move
rapidly to create a uniform general sales tax across all products and
states. More important, the total taxes on manufactured goods should
fall to 15 percent of retail prices (the current level in China) over the
next three years. Our study of a variety of product categories in India
and China shows that for every drop in prices of 25 percentage
points, consumption increases three- to fivefold. Also, the
government should reform indirect taxes such as excise duties levied
by individual states and lower import duties to 10 percent to boost
domestic demand and support manufacturing growth.
In addition, innovations such as special economic zones must remain
under consideration, despite recent controversies about them. To
accelerate manufacturing growth, these zones should have
governance structures insulating them from political changes and
pressures and offer simple administrative procedures, as well as a
world-class infrastructure, physically attractive environments, and
anchor tenants that plan to reach significant operating scale through
substantial capital investment. These manufacturers should also have
access to domestic markets using a dual-bookkeeping system similar
to that in China, where products sold locally are subject to local taxes
and duties on materials imported for their manufacture, while
products exported are not.

Economic engines in rural India

To ensure that India’s economic growth reaches the whole country,

the government must supplement the Bharat Nirman program with
job creation plans in the farm and rural nonfarm sectors. Such
initiatives, focusing on skills and assets already in place, could create
30 million to 40 million jobs in rural areas and increase rural incomes
by 1 percent annually over the next five years. For such plans to
succeed, India must launch a second Green Revolution,5 reform the
food industry, and create a thriving service sector in rural areas.

A second Green Revolution should embrace three features. First, the

country’s prime farmland should be expanded beyond the states of
Haryana and Punjab, into Bihar, Madhya Pradesh, and Uttar Pradesh.
This prime area would focus on growing grains such as corn and
barley. Some farms should be encouraged to replace grains with fruits
and vegetables, as well as livestock; historically, demand for these
higher-value products increases as economies develop and incomes
rise. Finally, wastelands—vast tracts that have low water tables and
infertile soil—should be cultivated with crops such as eucalyptus trees
and jatropha, which have global markets and can be grown
economically on relatively unproductive land.

Special tourism zones with tax benefits could generate as many as

25 million jobs over the next five years

Reforming the food industry is also important. Key measures include

amending laws such as the Agriculture Produce Marketing Committee
(APMC) Act (which restricts the retailers’ access to produce), creating
a legal framework for contract farming,6 and liberalizing the interstate
movement of produce. Over time, the government should shift its
role from market participant to facilitator. The systematic
development of the food-processing industry is also necessary to
make better use of India’s resources, since supply chain problems
prevent large quantities of produce from ever getting to market.

Finally, creating a vibrant service economy in rural India by focusing

on labor-intensive sectors such as tourism could be enormously
beneficial. Special tourism zones with tax benefits—an arrangement
similar to special economic zones for manufacturing but without any
need for the large-scale acquisition of land—could generate as many
as 25 million jobs over the next five years. These zones could attract
an additional 20 million foreign tourists annually, as well as 400
million domestic ones. Retail banking, health care, and education are
other service sectors that could grow significantly in rural India as
incomes and aspirations continue to rise.

India is on the verge of one of economic history’s great

achievements, which could lift hundreds of millions more of its people
out of desperate poverty and create a huge and thriving middle class.
But that won’t happen without a strong political commitment and
concerted action from all stakeholders—the government, the private
sector, and society at large.

About the Author

Adil Zainulbhai is a director in McKinsey’s Mumbai office.

Notes
1
India’s fiscal year ends in March.
2
Net capital inflows include long-term commercial debt, as well as
foreign direct and indirect investment.
3
Eric D. Beinhocker, Diana Farrell, and Adil S. Zainulbhai, “Tracking
the growth of India’s middle class,” The McKinsey Quarterly, 2007
Number 3, pp. 50–61.
4
The Ministry of Finance’s Committee on Infrastructure estimated in
May 2007 that infrastructure needs through 2012 would be $475
billion at current prices.
5
The first, from the late 1960s to the end of the 1970s, combined the
use of improved seed stock and of modern techniques, which
increased crop yields dramatically, as well as an expansion of
farmland.
6
Farmers plant crops for sale to a specific purchaser, often a food
processor, for delivery at a specified time and price.