Why India needs manufacturing and true labor reforms

Photo of Rajeev Dehejia

Rajeev Dehejia,
New York University and
IZA Bonn

The International Monetary Fund’s recent downgrading of the growth forecast for India from 6.2% to 4.5% for 2012, which came on the heels of the decline in the actual growth rate to below 5.5% in the first half of 2012, has brought reforms back to the center stage of the policy discourse. Which reforms are needed and why?

India’s growth trajectory has been a unique one. While most miracle-growth economies such as South Korea, Taiwan, and China were propelled by super-high manufacturing growth with a concomitant decline in the agricultural share of both GDP and employment, India has achieved its impressive annual growth of 8.2% over the last nine years with a stagnant share of manufacturing in GDP. While the share of agriculture in GDP declined significantly, agricultural employment has fallen at a snail’s pace. It is services that have surged in India, growing at double-digit rates. Some sub-sectors such as real estate and business related services have grown at astonishing rates of 20% or more during some years.

This unique experience has led some to argue that liberalization can claim little credit for India’s growth success – as the most prominent deregulatory reforms have targeted the still-sluggish manufacturing sector – and furthermore that, in view of the sluggish response of manufacturing, economic reforms to free up the labor market are unnecessary. But neither of these could be farther from the truth.

The economic liberalization of the 1990s and early 2000s has contributed to the growth in services in at least two ways. First, contrary to the reform critics, direct liberalization in service sectors such as telecom, banking, and civil aviation has been associated with galloping growth, notwithstanding the recent troubles of the last of these sectors. The claim that liberalization has been limited to manufacturing is a myth.

Second, and often overlooked, even if manufacturing wasn’t pulling up India’s average growth over the last decade, just keeping pace with GDP meant that its growth accelerated from the 5-6% range to the 8-9% range. In turn, this manufacturing growth has created a significant secondary source of demand for services, both directly for business-related services that manufacturing uses and indirectly for non-traded services such as restaurants, real estate, and tourism by contributing to rising incomes.

In recent work with Arvind Panagariya , I show that a one percent increase in manufacturing growth was associated with a one-for-one increase in services growth. We also dispel the bugaboo that services growth has not been inclusive; as entrepreneurs, the Scheduled Castes (SC’s), Other Backward Castes (OBC’s), and Scheduled Tribes (ST’s) have seen the value added and employment in their enterprises either keep pace with overall growth or even outpace it. The disadvantaged groups have capitalized on growth opportunities in services and narrowed their gap relative to the traditionally privileged Forward Castes.

While services growth thus has had a definite link to the reforms and has been inclusive, the Dehejia-Panagariya studies also point to why India can ill afford to ignore manufacturing growth. Looking just at 2006, we find that formal urban service enterprises accounted for 71.9% of total output, whereas they accounted only for 29% of employment. In other words, urban, formal service firms and the workers they employ are at least three times as productive as informal and rural firms, yet the latter categories employ more than 70% of the service sector workforce.

The contrast is even sharper when looking at growth. Formal firms grew at about 23% annually between 2001 and 2006, whereas informal firms grew at 3.5%. Looking at the largest firms this difference is even more dramatic: firms with 20 or more workers accounted for 21% of output in 2001 and 53% of service sector output in 2006, while their share in employment rose only from 7% to 10%. In other words, the productivity of workers in the largest service-sector firms has skyrocketed.

What is often forgotten is the flip side of the coin: that even within the booming service sector, there is a vast pool of highly unproductive labor, working in informal service sector firms, often rural, and often with a single employee, namely the proprietor. In other words, the challenge of raising the productivity of the Indian workforce is not only in agriculture but also in all but the largest service sector firms.

Given their limited skills, where will these workers find more productive employment? It isn’t realistic to take the paan-shop proprietor to an IT firm. Eventually, manufacturing – in particular labor-intensive manufacturing – is the only remaining answer.

This brings us back to the recent proposals for “reforms” of contract labor, minimum wage, and related labor laws. The proposed reforms go precisely in the wrong direction: they would raise the already high labor costs in the organized sector. While such increases may be popular with already well-paid and vocal organized sector workers, they will drastically cut the already meager employment opportunities in the organized sector for those informal, contract and casual workers toiling at subsistence wages or worse. India’s vast pool of low-skilled labor, whether in agriculture or services, can ultimately only be productively employed in large-scale labor-intensive manufacturing and that requires greater, not less, flexibility in the labor laws.

This op-ed has been published in the Indian daily newspaper “Indian Express”.

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