The India Story Part I: 1950-1991

From British Raj to Licence Raj

Introduction

We start with a brief history of industrialisation, the trajectory of East Asia, and the contrast with India. While there are many differences between India, China, Japan, Korea and Taiwan, the choices East Asia made were roughly similar, while India took a different policy. This difference in policies put these two on two entirely different paths.

Till the Industrial Revolution, a vast majority of the population was engaged in agriculture. They produced more than they consumed, and the surplus was taken as taxes. This was spent on armies, forts, civil engineering projects, or monuments and temples. With the creation of factories came the need for a large number of employees. Farm labour was easily available, and the excess from it was moved into manufacturing jobs. As efficiency increased, output went up, costs dropped, and living standards rose. What was luxury earlier became affordable to masses. Increase in agricultural yields enabled a very small fraction of the population, < 10% to provide enough food for everyone else.

Japan

The first Asian country to industrialise was Japan. It underwent a revolution in 1870, the Meiji Restoration, that restored the nominal emperor as head of state and industrialisation accelerated- railways, factories, shipyards were being built, the army and navy was modernised. One of the biggest industries at the time was textiles- Japan caught on quickly and by 1890s, was more competitive than India despite the latter’s head start. While part of Japanese industry was devastated during World War 2, the ‘know-how’ did not disappear. Japan invested heavily in literacy, schooling, early on, and this remained even after the war. The recovery was fast. Unlike India and China, which had lagged behind in accumulating expertise, the blueprints already existed in Japan. It was only a temporary loss of material. After the war, Japan specialised as a producer of low cost, low complexity products for exports to US. Due to free trade deals and a cheap currency, coupled with the knowhow, the economy grew fast. The surplus was invested into moving up the value chain- from low margin, low quality and cheap priced products to higher end products which required a lot of skill. By 1980s, Japan was known for quality, and Japan had surpassed US in per capita GDP and incomes.

A key feature in Japan, was zaibatsu/keiretsu. These were vertically or horizontally integrated conglomerates of sorts. A bank, a trading company or manufacturer would work closely. The company would have easy access to credit, and the bank would have deep insights in the business and a say in affairs. These groups held shares in each other and prevented outsiders from taking over. Many of these date back to pre war era, over a hundred years. This close cooperation between industry, finance and the government was a big help in the early days when competing with bigger companies in the West.

The other 2 countries in the region are South Korea and Taiwan. Korea split into two after the Korean war in 1949. The South was effectively taken over by US, which ensured its security. Both Japan and Korea benefited from not having to spend large sums on their military in the early days but carried the risk. Similar to Japan, both Korea and Taiwan built up an industrial base designed for exports to US. Taiwan had already been under Japanese rule since the late 1890s, and its economic networks were already integrated with Japan. As a group, these countries offered cheap manpower, great infrastructure, a skilled workforce, tariff free trade and proximity relative to each other. All of them focused on exports. In the next 4 decades, by 1980s, all of them were wealthy. Similar to Japan, as wealth and incomes grew, they moved up higher in the value chain, and the focus shifted to electronics, displays, cars, semiconductors. They still hold the edge in these sectors even today. The companies involved in low margin and low skilled manufacturing relocated their plants to China next door, or S.E Asia and the same model was repeated.

China

China is too large, and very different from the other smaller states of East Asia. In 1949, the Communist faction won over the mainland, establishing the People’s Republic of China. Between 1949 and 1960, China under Mao executed a number of landlords and redistributed land to peasants. Foreign investment was wiped out. The ‘Great Leap Forward’ led to famines that killed millions, followed by the Cultural Revolution, destroying its intellectual base. This mismanagement and chaos continued till Deng Xiaoping took charge in 1976. Under Dent, there was a sweeping reversal of policies - away from far-left and towards a market oriented economy. They instituted a one-child policy that capped population growth. The government focused on providing the basics- food clothing and shelter, and encouraged economic growth through state owned companies. Provincial authorities were given growth targets for exports and growth. Learning from the other East Asian successes, especially Singapore, SEZs were set up in Shenzhen, and other coastal cities. New cities were systematically planned and built from the ground up. From 1980 all the way to 2020, China invested heavily in infrastructure. Ports, power plants, roads, were built across the country at breakneck speed. This generated a lot of demand as well as economic activity, as the infra made Chinese exporters competitive internationally.

China followed a similar export-dependent model, but with a key difference- it invested heavily in infrastructure. For most of its growth phase, investment was a bigger contributor to growth than net exports! From the earliest days, most government spending went into infrastructure, education, sanitation, etc. There was no government backed social safety net. It remains non-existent even today. This freed up a lot of capital for investment in bridges, ports, railways, highways, and the excellent infrastructure made it a great destination for offshoring. Next, China granted conditional access to its market to foreign companies only if they operated as joint ventures and transferred technology to their local partner. This tech transfer helped Chinese companies drastically cut down the years they would need to spend in R&D to catch up. Meanwhile, the foreign companies got access to a big market, and local experience.

The timing was also crucial. The internet took off in mid 90s, and with it, it became popular to offshore manufacturing jobs to China from United States. In 2001, China joined the WTO, and this gave them tariff free exports to a lot of major economies. While it did not meet all the criteria needed at the time, the requirements were waived at US insistence, since it stood to gain the most from having cheap imports. Thus began a great boom- American companies off-shored manufacturing to China, who could make things for a fraction of the cost- due to their vast cheap labour force, excellent infrastructure, and tariff free exports to US. This had a snowball effect- profits were reinvested in more infrastructure, driving more demand within. To keep itself competitive, China bought US dollars and kept the value of its currency artificially low. This led to building up huge reserves of trillions of dollars from trade surpluses. The infra investments gave it economies of scale that no one else could match, making them even more competitive in exports. This also boosted real estate values, banking, and stocks. Between 1980s and 2020, China’s total GDP, as well as per capita GDP went from being the same as India, to being 4x of India.

India: “Never talk to me about profit, its a dirty word”

In 1950, India inherited an agrarian but intact economy, unlike China. Largely untouched by the Second World War, the Partition put a temporary strain. Its banking networks, trade, capital stock was intact. It had a central bank that had been operating for 15 years by then, and sizeable reserves. Its military industrial complex was also well run, with experience in the just concluded war. The Hindustan Aeronautics facility in Bangalore was used extensively to build or service some US airplanes in the 1940s.

In 1950, the world was split into two camps- one led by the Soviet Union under Stalin, and the other led by US. Both wanted to win over as many countries as they could, to their side. Nehruvian India declared a policy of non-alignment- they would be neither in the US bloc, nor Soviet. The other countries in the neighbourhood were more pragmatic, and China joined the USSR camp, while Pakistan leaned towards the US, joining CENTO.

India tried to have the cake and eat it too- commit to neither camp, but get concessions from both. This did not work out well, and it did not get much help from either side. In 1962, when China launched an invasion and occupied parts of Ladakh, India was forced to ask the US for help, as the USSR did not intervene. A decade later, the situation was reversed, with the US sending a carrier group in the Bay of Bengal in support of Pakistan, while the USSR sent a nuclear submarine in support of India. Neither led to any strong trade or military ties.

Licence Raj- Nehruvian Socialism and the “Hindu rate of growth”

While officially neutral, the Nehru led government was very socialist in its outlook, leaning towards the USSR in ideology, and wanted the state to micromanage the economy. Inheriting the ‘we-know-what-is-good-for-you’ view from the earlier British Raj, it believed the state could, and should decide how industry operated, down to minute details.

To this end, an extensive permit system was created- to start a business, or venture into a new one, you would need permits from the government. Available resources- raw materials, infrastructure were deemed critical, and the government was to be the allocator among the businesses that needed it. The requirements were not clear, they could change anytime, rules were arbitrary, and subject to change often. A businessman needed 50+ permits to open a new factory. JRD Tata, one of India’s greatest entrepreneurs, was famously told “Don’t talk to me about profit, its a dirty word” by the then Prime Minister Nehru.

This was not an exaggeration, as the government controlled all aspects of the business, even if it got the permits. It was practically impossible to fire anyone or close a business. This inevitably led to a crisis as imports soared and exports cratered. In 1966, the first of many such incidents to come, India devalued the Rupee substantially vs the Dollar, losing a third of its value overnight, from 4.7 Rs to 6.3 . This did not do much to help competitiveness. It was devalued again to 7.5 . Despite this, the Indian entrepreneur was still dealing with the Licence Raj, while his foreign peers were getting cheap financing, helpful treatment and tariff free exports from their governments. In the 1950s, the growth rate averaged 3.5%. Between 1960-66, the growth rate was 2%, at a time when Japan was growing at 12%. According to discourse of the time, this poor performance was termed “the Hindu rate of growth” - though Ive been unable to locate the verses in the Vedas that limit GDP growth to 4%.

The excessive regulation meant everything needed a permit. Narayan Murthy, the founder of the iconic Infosys, recounted that he had to visit the RBI 10 times to get a permit to visit abroad! The government would not allow them a fair market price to list the company’s shares either, and he had to argue with government bureaucrats to convince them why he needed specific computers from US for his business- A process that could take years!

1970s: Emergency and nationalisations

License Raj | India Before 1991

The first sector to be taken over by the Government was airlines- Air India, right after Independence. This was followed by taking over shipyards in 1960- Mazgaon Docks and several others.

In the 1969s, under Indira Gandhi, the country’s 15 largest private banks were taken over by the government in one go, as the government decided that it was time for them to micromanage the banking sector as well. After several rounds of nationalisations, the government owned 90% of banking in the country by 1980.

In 1972, this was followed by nationalising insurance companies. Next year, the coal industry was nationalised under a company Coal India, that had a monopoly for the next several decades. This was unable to produce the required quantity of coal, and India eventually resorted to importing large volumes despite having plenty of reserves!

In 1975, the major foreign oil companies got nationalised- Esso, Burma-Shell and Caltex. Known today as Hindustan Petroleum, Bharat Petroleum!

In 1976, came the FERA Act- which required foreign companies to dilute their shareholding in Indian operations to 40%- effectively making them a minority shareholder in their own local business. Exemptions were to be allowed- allowing the foreign owner to retain a 74% stake, if the sector was involved in exports, or a business that the government deemed useful. Several American companies involved in tech sectors like IBM and consumer brands like Coca Cola, preferred to exit the country rather than dilute their stake. This was a net loss to the Indian public at large, as they lost good products, and jobs created by those companies which required specialised skills.

By this point, the government was most of the economy. It controlled all insurance, banking, power, energy, rail, airlines, consumer goods companies were small local businesses, while foreign companies left.

Freight equalisation policy

To make industrial raw materials like iron ore, coal, etc available across the country, the government subsidised their transport. This made it cheaper to manufacture goods for exports on the coast, rather than building it close to the source of raw materials.

The coastal states benefited from this greatly, as they got subsidised raw materials, while the resource rich internal states lagged behind. This continued all the way to 1993! In China, its most populated cities are near the coast, while in India, the greatest density is inland up north. This policy ended up being a massive wealth transfer from already poor regions to wealthier regions.

Unions and strikes

Unions wielded considerable power, and regulations prevented sacking or closing any factories without government approval. Mumbai, a hub of textiles since the late 1890s, had lost competitiveness to foreign mills by late 1970s. A massive strike organised by the mill workers lasted for months, shutting down the already sick textile mills for good. Eventually, around 250,000 mill workers lost their jobs as the mills closed permanently, and the industry relocated elsewhere in the country- much to Gujarat. Some of the mills reopened almost 30 years later, converted into shopping malls, circa ~2010.

Outside textiles unions still wielded considerable power in other sectors- automotive was another. Production was capped, since unions limited how much output a factory would produce- regardless of demand. The waiting time for a new scooter - (there was only one available, in 2 colours) was about 8-10 years in the 1980s.

Taxes

On the personal tax front, Indira Gandhi hiked the highest tax rate to 97% in 1970. The rate was already high as it is, and this led to widespread evasion and increase of the infamous black money.

1991

This set of policies eventually resulted in loss of exports, soaring imports, permanent high inflation, and a balance of payments crisis. The RBI was dangerously close to running out of forex reserves to pay for oil and other imports. An arrangement was made with the IMF for a bailout, conditional on dismantling the Licence Raj. The RBI’s gold was set aside as collateral in return for the loan from the IMF. This marked the lowest point for the economy till then, and the 1991 budget dismantled most of the Licence Raj permanently. Lets stop here and compare now what India did vs its peers.

A comparison - India vs East Asia

  1. Focus on exports

    India never focused on exports, while all of East Asia did. As a low income country, producing goods for local consumption limits the rate of growth, as there isn’t much spending power. Exporting to a much bigger economy with higher spending power enabled faster growth, and adoption of new technology. This wasn’t unique to East Asia. European states that industrialised late focused on exports as an engine of growth first, before they got wealthy enough to rely on local consumer spending.

  2. Micromanagement of industry

    This was unique to India- in the sense of retarding growth rather than accelerating it. The Indian bureaucracy was, and in many ways remains a holdover from the British Era. It was designed to maximise resource collection from a continent, with scant regard for its effect elsewhere. Even today, the focus remains on revenue maximisation, and rules are designed under the implicit assumption of bad faith actions on part of the citizens - which are to be regulated down to the minute detail to ensure compliance.

    In Japan, multiple sectors collaborated to create economies of scale and give each other a leg up in the foreign markets- banks, manufacturers, and the government. In China, provincial leadership had growth targets that could be met by boosting the output of industries, ensuring cooperation. In India, the bureaucrat was evaluated based on his capacity to extract the most- growth was irrelevant.

  3. Infrastructure spending vs Social Spending

    All of East Asia spent heavily on infrastructure- power, roads, ports, etc and all of this directly helped in improving their competitiveness in exports. In return, the trade surplus gave them far more resources on hand to invest in further improvements to infrastructure.

    None of the exporters had any social safety net when incomes were low. Family was the social safety net. The strong leftist bent of Indian politics in a democracy, meant that every 5 years, the government had to spend more on handouts and social welfare than before to stay in power. If they did not, the opposition would run on that platform and win the elections. While social welfare state may be nice to have, it is a luxury that a high income country can choose to have. Money that could be spent on infra, was spent on winning elections and sacrificing a long term future.

    The resulting underinvestment and poor quality of infrastructure meant it was often cheaper to import things from overseas than make them inland in India and transport them elsewhere. Other than rail, which lacked enough capacity, roads were poor, power cuts were frequent, and petrol prices were very high due to taxes. This made local manufacturers uncompetitive vs others not just in the global exports market, but even domestically. A Chinese company could profitably sell a low value trinket in Mumbai for less than it cost a local company to manufacture!

  4. Democracy and rent seeking

    India’s populist politics relied on the state monopolising scarce resources. The regulations were a labyrinth. By restricting growth, the already scarce resources became more valuable, and enabled huge rent seeking opportunities for those who held power or wealth. In turn, the optimal choice for voters was to vote the person who promised them the most populist politics in return- this was done in the form of handing out reservations, free water and electricity for farmers, zero income tax on farming, free grains through ration shops, etc. These were massively leaky buckets too, rife with corruption, where only a fraction of the allocated resources actually reached the intended beneficiaries.

    In comparison, China did not have to worry about elections, and Japan, Korea, Taiwan were effectively one party states that never went populist when poor.

  5. Population growth

    Comparable in size only with China, the one child policy drastically reduced the need for spending, and boosted per capita incomes very fast in the 90s and 2000s. India had to grapple with spending more and more resources, as fast growing population along with ever rising populism put an enormous strain on state spending.

  6. Foreign investment and partnerships

    East Asia relied heavily on partnerships with Western companies for tech transfer, and offshoring. This was used to build expertise and networks for exports. MNCs in India focused almost entirely on manufacturing for the local market, rather than exports, and were subject to the same rent seeking extortion from the government. After the government forced them to dilute their holdings in their Indian subsidiaries, many companies exited entirely. They did not start returning until 1990s.

  7. Energy supply

    The oil output from Bombay High, at one point supplied close to 40% of India’s oil output. Precious little was done to explore more oil and gas. The price of both was heavily regulated, and foreign companies nationalised. Despite having sufficient coal reserves, inefficiency and lack of accountability for the PSU monopoly that mined it meant that we still imported coal. This energy dependence meant the economy was at the mercy of oil prices globally. After the first Oil Shock of the 70s, the economy spiralled into recession. Even in the late 2000s, as oil prices went from $30 to beyond $100, inflation was very high and the government was forced to subsidise fuel.

  8. Labour

    Labour was always a sore point for Indian businesses, right from the earliest days of industrialisation in the 1800s. India’s labour market has always been fragmented, heavily unionised, and laws have been very stringent, leaving little flexibility for laying off employees. In a country with a vast labour surplus and scarce capital, populist politics enacted laws that made it very difficult to have flexibility in hiring- thus raising its cost. This made mechanisation more attractive, and ironically, labour intensive businesses could be done only by those with sufficient money or muscle power. In contrast, East Asia did not have such powerful unions everywhere, and factory workers worked long hours with little pay. However, as industries moved up the value chain and the country got richer, pay went up in line with growth.

As an entrepreneur with little capital, it was virtually impossible to start a factory, or have resources to innovate or research. The only viable alternative was a trading business that imported/exported or transported goods. There was neither much payoff from R&D for a large company, as its domestic market did not produce enough profit for a surplus, nor for a foreign player, which saw the market as very small. Business got a bad rep as something “unethical” or a ‘price gouger’ among the country’s growing middle class. To get permits to operate and stay compliant, bribes were impossible to avoid. If you paid a bribe regardless of what you did, there was no need to spend resources on compliance/safety/other norms or pay taxes fairly. This government designed rent seeking licence raj left everyone worse off. Consumers got worse products at inflated prices. Governments got far less in tax and resources. Businesses got far less profits than their potential.

It is easy to look back in hindsight and say ‘x was a bad policy choice’. For someone who sits in the high office, they have to make do with imperfect information, rely on experts, and trust that they are getting the right advice. China also made poor decisions in the 1960s, but got it right by 1970s. There is little excuse for spending 40 years of almost the same ruinous policies, until forced to change due to imminent bankruptcy. In some ways, India rectified some of the problems in 1991, but others remain even today, 30 years later.

There is a good chance that we have finally turned the corner away from a race to the bottom in populism- in 2019 Lok Sabha elections, the opposition party ran on a promise of a sort of universal basic income for hundreds of millions of people, while the incumbent said otherwise- that it would bankrupt the government, and was not feasible. Whether this clarity arose from the understanding of its bad economics, or from lack of trust in the ability to deliver is uncertain, we can only hope it is the former.

Its not all doom and gloom though, there is an old joke- ‘American companies succeed regardless of their government, European companies succeed because of their governments, Indian companies succeed DESPITE their government’. In the next part, we’ll see what happened after the 1991 reforms, why the IT industry took off, and how the economy grew from 1991 till the slowdown and currency crisis of 2013.

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Have a great weekend!

-Prathamesh Godbole