Industrial development and economic growth: Implications for poverty reduction and income

5.2 India
The economic development strategy that India chose after the Second World
War was very similar to China’s – near autarky, industrialization and the
dominance of the state in the economy. Development was considered syn-
onymous with industrialization and industry was concentrating mainly on
basic goods like steel and machinery. Private capital was not seen as an effi-
cient motor for development, and it was considered to have a tendency
towards monopolization. Because of that, state control was considered to be
essential. The chosen development strategy was one of import substitution.
Development policies included licensing of industrial activity, the reservation
of key areas for state activity, controls over foreign direct investment, and
interventions in the labour market (Kaplinsky, 1997). 
As the chosen strategy turned out to be ineffective, bureaucratic and
conducive to rent-seeking behaviour, policy reforms were started in the
1980s, and some provisional moves to encourage capital-goods imports,
rationalize the tax system and relax industrial regulations were made. In the
1980s, however, reforms were less consistent than in China, and they only
became systematic and broader at the beginning of 1990s, following a severe
macroeconomic crisis. Acceleration of economic growth, however, started
already in the 1980s, and Rodrik and Subramanian (2004) and DeLong
(2001) consider the reforms and attitudinal changes of the 1980s as impor-
tant reasons for India’s current success. In the 1980s, the allocative role of the
state in India’s industrialization remained important, and only after the 1991
reforms did the driving force of resource allocation shift in favour of the mar-
ket. The reforms undertaken in 1991 and thereafter included relaxation of
the licensing system controlling internal production, currency devaluation,
relaxation of restrictions on the inflow of foreign capital and technology
transfer, abolition of quantitative restrictions on imports of raw materials,
intermediates and capital goods, reduced tariff levels, relaxation of rules
restricting large companies to expand existing units and construct new ones,
and simplification of exchange controls (Kaplinsky, 1997). Furthermore,
reforms included breaking public sector monopolies, reducing foreign cur-
rency debt dependence and tax reforms. However, most of the restrictive
labour legislation was left intact and, in addition, the agricultural sector was
left largely untouched. In general, the approach to liberalization in India has
differed from the standard, Washington consensus, approach. Liberalization
has been gradual and controlled, slow liberalization of trade and very grad-
ual privatization have been emphasized, and capital account liberalization has
been avoided thus far (Jha, 2002). 
During the past 40 years, the Indian economy has undergone remark-
able structural change. The share of agricultural value added in GDP has
more than halved between 1965 and 2005, from 45 per cent to 19 pre cent
(Figure 3). Despite structural changes, agriculture still accounts for a very

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high share of employment. At the same time, the expansion of services has
been sizable, with its share of GDP increasing from 35 per cent in 1965 to
54 per cent in 2005. In contrast to many rapidly growing developing coun-
tries (especially in East Asia), there have not been sizable changes in the share
of manufacturing (16 per cent in 2005 vs. 14 per cent in 1965). The share
of textiles and clothing in manufacturing value added decreased between
1965 and 2000 (from 25 per cent to 13 per cent) (World Bank, 2006). The
share of machinery and transport equipment was 19 per cent of manufactur-
ing value added in 2000 (roughly the same as in 1965) and the share of
chemicals was about the same (up from 10 per cent in 1965), with much of
the increase in the 1990s. 
In the 1980s and 1990s, GDP growth was moderately strong in India,
the compound annual growth rate being 5.8 per cent in the 1980s and 5.4
per cent in 1990-2002. Growth has been occurring mainly in manufactur-
ing and services. Between 1980 and 2002, the growth rate of manufacturing
value-added averaged 6.6 per cent and that of services 7.1 per cent, while
agriculture grew at only 2.8 per cent per year. In the 1990s, growth was
remarkable in services. 
High growth has been accompanied by increasing trade flows. For exam-
ple, during the period 1991/92-2001/02, India’s gross trade flows almost
tripled, and the trade-GDP ratio increased from 21.3 per cent to 33.1 per
cent. Growth has been especially rapid in services exports, which grew by
275 per cent, whereas merchandise exports grew by 145 per cent (Kelkar,
2004). The share of manufactures in merchandise exports has been increas-
ing gradually but significantly. In 1962, manufactures made up 43 per cent
of merchandise exports, while in 2003 the share was already three-quarters.
Food exports comprised 11 per cent of merchandise exports in 2003 (World
Bank, 2006). Within manufactures exports, light industries have signifi-
cance, especially textiles and clothing. Gems (part of sub-category 66 in
Figure 4) are also important exports. Recently, India has developed signifi-
cant exports of chemicals, mostly drugs and dyes, and automotive compo-
nents (Economist Intelligence Unit, 2005a). 
In addition to rapid GDP growth, a sharp reduction in growth volatili-
ty has been important for the Indian economy. In the 24 years after 1980,
the standard deviation of GDP growth has fallen to 1.9 per cent (Kelkar,
2004), one reason being the shift in the sectoral composition of output and
the decrease in the importance of agriculture. 
According to government estimates (presented e.g. in Srinivasan, 2004),
the proportion of poor people in the total population (using national pover-
ty lines) declined from 45.7 per cent in 1983 to 27.1 per cent in 1999–2000
in rural areas, and from 40.8 per cent to 23.6 per cent in urban areas. For
the country as a whole, poverty declined from 44.5 per cent to 26.1 per cent.
The widening of regional disparities has, however, been significant. After
reforms, per capita expenditure differences between states have increased,

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with already better-off states growing more rapidly than poorer states
(Deaton and Drèze, 2002). Southern and western states have been doing rel-
atively better, as they have been able to utilize the opportunities of globaliza-
tion and the market economy, whereas in some other states weaknesses in
human capital and governance have generated reduced growth rates in the
post-1990 period (Kelkar, 2004). Furthermore, rural-urban disparities of per
capita expenditure have risen (Deaton and Drèze, 2002), even if inequality
has increased faster within urban areas than in rural areas (see e.g. Deaton
and Drèze, 2002; Jha, 2002). Due to slow liberalization, however, changes in
inequality following reforms have been relatively modest in India compared
e.g. to transition economies (Jha, 2002). 
The impact of the reforms of the early 1990s on manufacturing firms
depended, inter alia, on their location and technological level. According to
Aghion et al. (2003), liberalization fostered innovation, profits and growth in
industries that were close to the technological frontier, while it reduced them
in industries that were far from the frontier. Also, pro-worker labour regula-
tions at state level discouraged innovation and growth in all industries and
this effect increased with liberalization (Aghion et al. 2003, 2006). Lall and
Chakravorty (2004) conclude that structural reforms have had different
impact on different states. In seeking efficient locations, private sector invest-
ments favoured existing industrial clusters and coastal districts, whereas state-
owned industry has been less oriented towards such locations (Lall and
Chakravorty, 2004). Due to reforms, the role of the state as industrial owner
and industrial location regulator has been substantially curtailed and the
dominance of private sector industrialization has increased, which is likely to
lead to higher inequality between regions. According to Mishra and Kumar
(2005), however, trade liberalization has decreased wage inequality in indus-
try. In sectors with large tariff reductions, wages increased relative to the
economy-wide average. Since the tariff reductions were relatively larger in
sectors with a higher proportion of unskilled workers and these sectors expe-
rienced an increase in relative wages, these unskilled workers experienced an
increase in income relative to skilled workers (Mishra and Kumar, 2005).
The sectoral composition of growth is likely to matter to the aggregate
rate of poverty reduction and changes in income inequality. Jha (2002) argues
that the rise of inequality during the years of rapid growth has been due to a
shift in earnings from labour to capital income, rapid growth of the services
sector, a decrease in the rate of labour absorption during the reform period,
and rapid growth of banking, financial institutions, insurance and real estate.
Real wages for agricultural labourers have grown at around 2.5 per cent per
year in the 1990s, whereas public sector salaries have grown at 5 per cent per
year (Deaton and Drèze, 2002), which is one of the reasons for increased
inequality between rural and urban areas. According to Ravallion and Datt
(1996), changes in poverty (during the period 1951-1991) have responded
more to rural than to urban economic growth. They also argue that primary

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and (informal) tertiary sector growth has had greater impact on poverty than
secondary sector growth. Over the long term, the secondary sector has not
been a significant source of poverty reduction (Ravallion, 2004). One reason
for that is likely to be high inequality in human resource endowments, pre-
venting the poor from participating in the non-farm formal sector (see e.g.
Ravallion, 2004), especially in the more skill demanding activities. As
absolute poverty in India is principally a rural problem, the greatest poverty
reduction can be attained by emphasizing rural development, in particular,
agricultural development. In some regions, however, poverty reduction is not
possible through investments in agriculture, and employment in manufactur-
ing or services is the only possible way to reduce poverty.
The reform process has had clearly beneficial effects on the Indian econ-
omy. Growth rates have been high and growth more stable than earlier. The
service sector has expanded particularly rapidly, in terms of both output and
exports. Along with economic growth, poverty has significantly declined.
India’s economy, however, still confronts many obstacles hindering its
growth. Limiting factors for development have included: an inefficient legal
system and extensive regulations like those of the labour market; a low sav-
ings rate which has limited capital formation; a minor role for FDI, especial-
ly when compared to China; lack of access to finance, especially for small
businesses; high tariff levels which restrict competition in domestic markets
and hinder the development of potential exporters.