The Congress party's surprise election victory in India this month was greeted with dismay by investors. Stock markets plunged because of fears that Congress's communist allies would oblige it to scale back the country's economic reform programme. Since then they have rallied, reassured by the reformist credentials of Manmohan Singh, the new prime minister, and Palaniappan Chidambaram, the finance minister he appointed on Sunday.
Mr Singh and his ministers must not waver on reform if they are to retain investor confidence. That does not mean ignoring India's voters, who have sent a clear message about the need for economic growth that benefits all sections of society. But they must be careful how they interpret that message.
The experience of India and its Asian neighbours shows that continuing rural poverty stems not from too much economic reform but from too little. Since liberalisation began in 1991, annual growth in gross domestic product has been twice as high as it was previously, with the result that poverty rates have fallen by nearly a third in both rural and urban areas.
The celebrated software and outsourcing industries are only the most conspicuous evidence that reforms work.
The economic challenge facing the new ruling coalition is to extend the success of the information technology and outsourcing industries into the broader economy. This will require opening more sectors—including some in which the government plays a significant role—to foreign direct investment (FDI) and global competition.
Although India has broadly cut import duties and increased foreign ownership limits over the past 10 years, large parts of the economy remain sheltered by high tariffs and restrictions on foreign investment. FDI amounts to just 0.7 per cent of GDP, compared with 4.2 per cent in China and 3.2 per cent in Brazil. Imports total less than Dollars 70bn, a fraction of China's Dollars 413bn.
Research by the McKinsey Global Institute indicates that the FDI that has found its way to India has had an overwhelmingly positive impact. The introduction of foreign competition in information technology, business process outsourcing and carmaking has prompted Indian companies to boost productivity, and some have become formidable global competitors. Consumers have benefited from lower prices, higher quality and greater choice. Domestic demand has soared and thousands of new jobs have been created in these industries.
How can these successes be replicated across the economy? First, tariffs should be lowered to an average of 10 per cent, matching India's neighbours in the Association of South East Asian Nations. Tariffs on many goods still in effect prohibit imports and protect inef ficient companies from foreign competition. To lessen the shock the government might first lower duties on capital goods and inputs and then, over several years, lower tariffs on finished goods.
Foreign ownership restrictions should be lifted too. Without FDI it is doubtful that India's outsourcing industry would have taken off. Yet foreign ownership is prohibited altogether in industries such as retailing, agriculture and property, and is limited to minority stakes in many others such as banking, insurance and telecommunications.
India's leaders should also reconsider the expensive—but often ineffective—incentives it offers foreign companies to attract investment. The government often gives away large sums of money for the sake of investments that would have been made anyway. For instance, it waives the 35 per cent tax on corporate profits for foreign companies that move business process operations to India despite the fact that it would almost certainly attract these same investments even if they were taxed. State governments often end up in unproductive bidding wars, vying to give away tax holidays, import duty exemptions and subsidised land and power. Yet foreign executives place little value on these incentives. Most would rather the government devoted its resources to upgrading the country's poor infrastructure.
They would also like to see reforms to India's labour laws. It is no coincidence that software and outsourcing companies are exempt from labour regulations such as those regarding hours and overtime. Many executives say that without these exemptions it would be almost impossible to perform back office operations in India. The government should therefore consider making labour laws more flexible in order to attract foreign investment in labour-intensive industries.
Some might argue that the reforms proposed here are antithetical to long-held social objectives. But the evidence shows the opposite is true: regulations on foreign investment, trade and labour have slowed economic growth and lowered living standards. A decade ago India's income per capita was nearly the same as China's; today China's is almost twice as high.
India's economy has made real progress, but further liberalisation is needed. The country now has 40m people looking for work and another 35m will join the labour force over the next three years. Creating jobs for them will require more dynamic and competitive industries across the economy. Opening up to foreign competition, not hiding from it, is the answer.
Diana Farrell is director of the McKinsey Global Institute. Adil Zainulbhai is a director in McKinsey's Mumbai office.
This article originally ran in Financial Times.
