Special Report: India - The rocky road to reform

India's undoubted strengths do not compensate for a dismal lack of infrastructure and a regulatory jungle that impedes progress.

by Michael Backman and Charlotte Butler, INSEAD
Last Updated: 23 Jul 2013

At the World Economic Forum in Davos in January 2006, India was, as its slogan announced, 'Everywhere'. Politicians and global business leaders alike queued to pay homage to a new star on the world stage. Phrases such as 'economic powerhouse' and 'the Indian century' appeared in the media and, suddenly, India was all things to all people - for politicians, a strategic ally in the region; for business, the perfect destination for outsourcing ambitions, a source of R&D innovation and a potentially huge market stocked with middle-class consumers ready and willing to spend.

India's most frequently cited relative strengths are a sizeable pool of educated workers, management talent, rule of law, transparency, cultural affinity and regulatory environment. Its weaknesses usually centre on its slow-moving government and dismal infrastructure. So although many pundits argue that India could soon eclipse even China - its democracy, English language capability and a young population being its chief trump cards - the country first needs to address fundamental areas of reform.

Mainly, this is a question of political will. India is a dynamic but fractious democracy. The ruling coalition, led by the Congress Party, relies for its parliamentary majority on several Communist parties that oppose many reforms and which often act as an opposition group. In 2005, the left-leaning parties forced the government to abandon plans to sell its stake in 13 state-owned companies to strategic investors.

As a result, the hand of government over the economy still lies heavy; privatisation began in 1991, but even in 2004 seven of the country's 10 biggest companies (measured by sales) were still majority-owned by the state. State-owned banks control 90% of deposits and the railways employ more people than any other commercial organisation in the world.

Although the government works to five-year plans, its promised key reforms, notably in the labour and power sectors, are routinely delayed - largely due to opposition from the left. The result is that India's notorious regulatory jungle lives on and continues to impede progress. A 2004 study found that each industrial unit was still visited by between 40 and 60 inspectors in the course of a month, and that Indian managers spent 16% of their time dealing with government officials.

Foreign investors and local entrepreneurs have long waited in vain for the deregulation of India's labour market. The Industrial Disputes Act restricts the ability of managers of firms with more than 100 employees to fire staff. The impact of such rules on India's competitiveness and flexibility was sharply illustrated when global textile quotas ended on January 1, 2005. India, with its huge domestic cotton industry, spinning and weaving experience and cheap labour costs, was expected to benefit more than any other country. Instead, it was China that took full advantage - its exports jumped by 59% in the first quarter of 2005, against India's miserly 5% growth. A significant reason for India's poor showing was that its textile firms were reluctant to expand their workforces because of the difficulties of laying off staff subsequently.

Some cautious progress was made towards opening up some industries in 2005 when the government allowed foreign firms to enter the construction and property industries. India also signed an open-skies agreement with the US and passed a patent law that met WTO standards. But politics and organised interests combined to keep many FDI restrictions in place. Banking liberalisation is not scheduled until 2009 and in the insurance sector, foreign insurers can buy only 26% of Indian counterparts. Until recently, foreign firms wishing to set up shop could do so only via franchise operations.

Perhaps the most closely watched sector has been India's $200 billion retail industry. The big global players, Wal-Mart, Carrefour and Tesco, are eager to enter India, but the government fears for the impact on the country's 9 million small shops. "The issue is being looked at closely" has been the constant refrain and domestic retail groups have asked for another two to three years in which to prepare for liberalisation. In January 2006, a new measure was passed that allows foreign firms to take a 51% investment in single brand retail operations, meaning they will be able to operate their own stores.

The state of India's infrastructure is, arguably, the biggest obstacle hampering its economic development. One estimate of the investment in infrastructure needed by India in the decade to 2015 is $440 billion.

But it's extremely unlikely that anything like this sum will be invested, given persistent public sector budget deficits and the recurring alienation of private investors in Indian infrastructure projects. In February 2006, Rajeev Chandrasekhar, an ex-telecoms entrepreneur, summed up the frustration: "Business has been growing feverishly in India, now it is heading like a rocket into a dead end. That dead end is a lack of transportation infrastructure."

Both the badly run state-owned railway network, comprising 63,000 km of track, and the 3.3 million km road network (only 57% of which is paved) slow the passage of manufactured goods. In the inefficient and congested ports, India's lead time for an export consignment to the US is between seven and 12 weeks. In China, it is between three and four weeks. In 2004, the Indian government began a 15-year project to widen and pave about 65,000 km of otherwise decrepit, narrow national highways. It is a huge undertaking that will cost tens of billions of dollars. The first stage to be completed will be the highways that cut across and ring India, linking Chennai, Mumbai, New Delhi and Calcutta, at a cost of more than $6 billion.

At the beginning of 2006, Indian airlines collectively owned less than 200 jets. But if 10% were to fly routinely, then India would probably need about 2,000 jets. But could India's 330-odd airports cope? As it stands, aircraft spend more time on the ground than in the air as ground staff struggle to cope with out-of-date facilities. Airports are under-capitalised, most are not privatised and suggestions that they should be are typically met by strikes. Cargo carriers such as FedEx are prevented by law from flying domestically. They must fly to Mumbai or New Delhi and then continue by road. It is a ridiculous situation for a county that aims to be developed by 2020. It's little wonder that India's services sector has become the star export earner: services don't need to be physically carried.

However, with its billion potential consumers, India is a mouth-watering prospect and as big an opportunity as China. Foreign investors are particularly excited about India's new middle class and young generation of IT workers.

Willing to spend on foreign brands and optimistic about their own and the country's future, they are a highly attractive group. But investors should remember that India's middle class is still only about 15% of the population. Moreover, the fruits of India's economic success have been limited to the urban population of a few high-growth areas - Mumbai, Bangalore, Delhi and the southern corridor. Roughly, 70% of the Indian population lives in the countryside, vulnerable to the vagaries of the monsoon and with little opportunity to improve their lives. Impoverished states such as Bihar and Orissa have been left way behind.

Nevertheless, the portents are extremely good. In 2005, the highest number of jobs were created since 2000 and that year saw the biggest salary rises.

Between 1995 and 2004, the credit card subscriber base grew by 35% annually.

In 1975, Indian consumers had a choice of three car models; by 2004, there were 90. By the end of 2006, India is expected to be the second largest market for cell phones and among the top 15 for airline passengers. The luxury end of the market has been encouraged by the changing rules in the retail sector. According to a report in the Financial Times in February 2006, 1.6 million households earn $100,000 or more a year and spend $9,000 a year on high-end designer goods, translating into a market worth $14.4 billion. The number of households in that segment is said to be growing by 14% each year, and to meet their needs, 93 new shopping malls are planned by 2007.

Although services still dominate India's exports sector, the signs are that manufacturing is taking off. It has started to enjoy its fastest growth in memory, expanding 9.8% in the five months to August 2005 compared with the same period in 2004, and business confidence indices are at their highest levels since 1995. Manufacturers might have further taken heart from reports early in 2006 that China's manufacturing competitiveness is being eroded by rising energy and labour costs, so that it is no longer the most cost-effective country in the region. Exports in the seven months to October 2005, of which 75% were manufactured products, were up 22% on the year before. However, in 2005 India's exports accounted for 0.8% of world merchandise, China's for 6.4%.

Considerable excitement has centred on the telecoms industry. By 2005, it had more than 115 million mobile telephone subscribers and analysts forecast that 2 million new subscribers would sign up each month over the next 12 months, making India the world's fastest growing mobile telecoms market. In fact, the numbers have fallen short of this target, but given the market potential all the big players - Alcatel, Motorola and Nokia - have started operations there. To encourage local production, the government has imposed a 4% duty on imported handsets.

Drugs manufacturing is another bright spot, largely on account of the large domestic market that allows the sector massive economies of scale without the need to export. However, before exports can really take off, India still has some significant intellectual property rights issues to solve. In the short term, high-tech manufacturing, based on India's reputation as a software and R&D hub, has the most promising prospects. India's R&D capabilities are highly rated sources of innovation for western firms such as Intel, Motorola and Cisco, which in November 2005 announced a $1.1 billion investment in India, mostly in R&D. By 2006, over 150 international companies were doing research in India. China trailed with only 40 companies.

India appears a great place to invest and attracts a lot of excited talk.

But is it a great place to make money? The vast majority of outside investors will still find that the answer is no. India is getting better, but the hyperbole comes by measuring India against where it has come from and not by comparing it to the world's truly wealthy and mature economies.

- This is an edited extract from Big In Asia: 30 strategies for business success, Michael Backman and Charlotte Butler, Palgrave MacMillan, 3 November 2006, £19.99, ISBN: 0-23000-027-4.

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