Amartya Lahiri and Devashish Mitra on Trade and Manufacturing-Led Economic Growth in India

SHRUTI RAJAGOPALAN: Welcome to Ideas of India, where we examine the academic ideas that can propel India forward. My name is Shruti Rajagopalan, and I am a senior research fellow at the Mercatus Center at George Mason University. 

Today my guests are Amartya Lahiri and Devashish Mitra who are joining me to discuss their latest paper for the 1991 project titled India’s Development Policy Challenge. Amartya Lahiri is the Royal Bank Research Professor in the Vancouver School of Economics at the University of British Columbia (UBC). Devashish Mitra the Gerald B. and Daphna Cramer Professor of Global Affairs at the Maxwell School of Citizenship and Public Affairs, Syracuse University. We spoke about structural transformation and increasing total factor productivity, manufacturing versus services led growth, industrial policy, export led growth, how to employ India’s youth in more productive sectors, and much more.

For a full transcript of this conversation, including helpful links of all the references mentioned, click the link in the show notes or visit mercatus.org/podcasts. 

Hi, Amartya. Hi, Devashish. Devashish, welcome, you’re here for the first time. Amartya has been here before. Amartya, welcome back.

DEVASHISH MITRA: Thank you.

AMARTYA LAHIRI: Good to see you.

State of India’s Structural Transformation

RAJAGOPALAN: Great to see you both. In a recent working paper that you’ve written for us at Mercatus’ 1991 Project titled “India’s Development Policy Challenge,” you both argue that India’s best bet for economic growth is to create a large labor-intensive manufacturing, firm-driven economic growth. This is mainly done by encouraging merchandise exports and so on. 

Before we get to that paper, I just want to get a sense from both of you on where we are in India’s structural transformation at the moment. On this, Devashish, you’ve written a lot before. This is one of your papers with Will Martin. You’ve looked at total factor productivity in agriculture and manufacturing, and how TFP [total factor productivity] growth rates and convergence takes place. I think what you found for India and many other countries is that agriculture does better than one would anticipate or one would imagine. 

Then other than increasing total factor productivity within each sector, there’s also the question of structural transformation or structural change. Where do you have greater productivity arising from movement of different factors from one sector to another? Which is also something that you’ve written with Reshad Ahsan and so on. How do you see that in the current moment in India? I ask specifically because these papers are now a couple of decades old.

MITRA: The paper with Will Martin is very old. We started work on this when I was a summer intern at the World Bank. First summer, we didn’t finish it, but couple of years later when I had finished my Ph.D., that very summer after I defended my Ph.D. dissertation, I went back to the World Bank and we finished that paper. It’s basically 28 years old. It’s cross-country work. Basically, the data is from 1967 to ’92, so 25 years of data across many countries. 

What we found was that TFP growth on average for all those countries—the sample included a bunch of developing countries as well—what we found was that the TFP growth was higher for agriculture than manufacturing by somewhere between 0.5 and 1.5 percentage points. Also, there was much more convergence in productivity within agriculture across countries than in manufacturing probably because innovations in agriculture spread much faster and much more easily. IPR is not a big problem when it comes to spread of high-yielding varieties and so on. Maybe that’s what was happening, but the data ends in 1992.

That’s about 32 years ago. I don’t know whether it’ll hold, but of course, the productivity levels are much higher in manufacturing than in agriculture. When I was doing my work with Reshad Ahsan on structural change and growth in India, we did find that manufacturing productivity was much higher than in agriculture. Some of the services like finance and some of the business services, it was even higher, quite a bit higher than manufacturing. Now, a lot of the structural change, that is for a slightly later period because if I remember right, it ends 2005 or 2010. I don’t quite remember the work with Reshad. It was just for India post independence up to 2005, I think. There, we actually find that India, all the structural change that had taken place, even though it was little, was growth-enhancing. 

McMillan and Rodrik have this framework where they have growth-enhancing structural change and growth-reducing structural change. If resources are moving from low-productivity to high-productivity sectors, then you’re getting growth-enhancing structural change. Most of the structural change that has taken place in India is growth-enhancing, except for the ’70s where structural change had a negative contribution to growth. The contribution of structural change to growth has been pretty small. If you look at the post-liberalization period, most of the growth is coming from within sector growth.

Within sector productivity, growth is contributing most to overall growth. You’re not getting a lot of growth out of structural change. Little bit. It’s positive, but it’s small and the contribution is a small fraction of the overall growth. That’s why I think there’s a lot more to be done in terms of structural change. A lot of the structural change that has happened in India is also moving resources to the services sector. Manufacturing still has a low proportion of employment as well as value-added, hasn’t grown much over time in terms of shares, but services have.

Basically, a lot of the reduction in the proportion of GDP that we can attribute to agriculture, that has been taken by services, most of it. Some manufacturing, but most of it services. The problem with high-end services is that India doesn’t have a labor force that is skilled enough to move into services. We’ll talk more about that later. Given the current level of skills and skills in the near future, labor-intensive manufacturing seems to be the best bet. The only way to increase employment there is to actually produce just not for India, but also for the rest of the world, meaning manufacturing exports.

Has India’s Growth Peaked?

RAJAGOPALAN: Before we get a little bit further into that, just trying to understand now, particularly the post-liberalization, post mid-’80s or 1991. When you separate the two parts of the growth that’s taken place, one is greater productivity within individual sectors, and the second is the productivity arising out of movement of resources or factors of production from one sector to another, it seems like most of the work has happened in the former. We’ve chugged along at 5%, 6% average growth because there was a lot of underutilized capacity within each sector.

Initially, because of License Permit Raj and then eventually because of trade liberalization, import substitution, just the constraints of getting foreign exchange, acquiring technology. That seems to have taken us a pretty long way. Do you think India can chug along at this 5%, 6% growth just by finding improvements within sectors the way the Indian economy has done in the last 30 years? Or now we’ve peaked or hit the limit of that and now some kind of shift of resources or factors between sectors has to happen or it’s all going to collapse?

MITRA: I don’t think growth is going to be that big a problem. The problem will be growth in GDP along with growth in jobs. Whether that can happen or not is the real issue because if you look at the growth we’ve got so far over since, let’s say, 1988 to 2003, was roughly 6% on average. 2003 to 2012, slightly over 8% on average, then it went down a bit. We are back to about 7%, 8% growth again. I cannot pinpoint just one thing that is driving growth, but there are many things that might be driving growth.

Technological change all over the world is benefiting India as well, I think. Technology hasn’t changed at this rapid pace in a long time. A lot of the technological change also is leading to more automation, more digitization, more capital deepening. It’s not clear that the growth that we get will automatically create jobs. That is where the challenge lies. We’ve talked a lot about the demographic dividend and how that actually could turn into a demographic curse and all of that in the paper. The challenge really is to create good high-paying jobs, high-quality jobs along with growth. I think we’ll get growth but I’m not sure that we’ll be able to absorb this addition to labor force that’s taking place every year, like 10 to 15 million people a year.

RAJAGOPALAN: Amartya.

LAHIRI: I think broadly I agree with what Deveshish said. Probably I’m a little more skeptical about the growth prospects in the sense that based on the way the numbers have been coming in for the last decade or so, it just seems to me that we are possibly looking more at settling around, rather than 7%, 8%, settling somewhere around 5.5%, 6%, is where probably it’s more likely to settle. That’s my gut feeling. Just looking at the data from the consumption side and from the production side, there’s a bit of a mismatch between them. 

Which may be related to demand as well, but at some level, to sustain anything, you need both sides of the coin to be playing together because you can’t just have one side. I’m a bit more skeptical. Where this becomes more challenging is when you juxtapose this kind of situation with the aspirations that have been unleashed in the country. That is where we, I think, potentially have a massive challenge. Some political economy challenges, some just baseline civic society challenges that if the aspirations of the population and very young population is not in sync with what the economy is delivering.

For us to meet those aspirations, I think we need to be growing at maybe not China-like rates, but pretty close to it. It has to be sustained couple of decades of 8% to 9% growth in order for the economy to get to a point where at least have the resources that it can distribute, at least at a statistical sense, the income over a big chunk of people to lift their incomes in a very perceptible way. 

Then there is a second challenge, which is even if we could produce 9%—then we can discuss what may be the way to go. This is where I think deep-set structural reforms, the second round of reforms as you were hinting at, I think it’s just fundamental. There is a second issue of how do you distribute this, even if we can get it? That is the second challenge, which is where the whole issue of how you incentivize firms and you incentivize manufacturing, I think for us is key. Otherwise, you’re just going to be looking at a redistributive state that can sustain growth produced by very few, which is then distributed through other kinds of welfare schemes, which are not necessarily all things that there is political unanimity on.

There are moral issues as well about how much you can sustain by just distributing to people, which will come with other kinds of issues. I think there is a challenge in growth. I’m not so sure. I think Devashish is right that it’s not going to be the pre-1980s kind of situation. We are definitely not there. We’ve gone to a point.

The aspirations demand something about 8% to 9% on a sustained basis for about 10 to 15 years at least. I’m afraid we’re running out of steam on that. That’s where I think we do need. This is where the deeper second-round reforms have to be on factor markets. There are two really crucial ones, and then there are ancillary ones. That’s labor and land policies. We can get into that. I broadly agree with Devashish, except I’m a little more afraid that the growth is not going to be at the level that we would expect.

Trade-, Export-, and Manufacturing-Led Growth

RAJAGOPALAN: This is just for the young kids who didn’t grow up like me on the trade- and export-led, manufacturing-led growth miracles of South Korea and China, and everything. Can you just briefly lay out the mechanism which you also talk about in the paper? This idea that exporting firms tend to be both larger in scale, they tend to be more efficient than the firms that just produce for the domestic or the local market.

There is a particular kind of disciplining mechanism that comes from international competition, which brings in more efficiency, which brings in technology diffusion, innovation of all sorts. Incidentally, they also end up employing more people because they have these economies of scale. Can you walk through the mechanism of this trade liberalization, export-led growth in terms of overall productivity, firm productivity and then, of course, increased employment and labor productivity?

LAHIRI: Devashish, do you want to take this?

MITRA: Yes. We’ve talked about a few things in the paper, but overall there are so many different channels through which trade liberalization can lead to higher growth. I probably will not be able to come up with an exhaustive list. There is this X-efficiency factor, higher competition and you’re competing with the best in the world. That’s the simplest. Also to compete, you have to keep on doing your R&D to basically produce your best-quality product and also try to produce it in the cheapest possible way to be able to survive that competition.

That’s pretty straightforward. That’s basically import competition. Exports also can work the same way because then you competing in export markets with the best in the world. You’re not competing in your own market. You’re competing with firms from other countries, the top firms from other countries that are exporting to the rest of the world. There’s also something from the input side when you get cheaper inputs because you’ve opened up trade, you’re going to be more productive. 

Apart from that, there is also at the macro level some resource allocation issues. For example, and we’ve talked about that in the paper, it all boils down to Lerner Symmetry. If you actually have import restrictions, you are basically moving your resources toward production of import-competing products. You have fewer resources to produce for exports. Or there’s also the exchange rate channel which is that basically you’re reducing the demand for foreign exchange, and that’s leading to the appreciation of your own currency which is making your own products more expensive abroad and so on. Your exports are being hurt. There are various channels through which trade liberalization will benefit economic growth. This is just a very small fraction of the channels we can think of.

LAHIRI: Just to elaborate on what Devashish said. One, a systematic study that this Khandelwal and company paper in the QJE from 2017, people without an economics background call this the chicken and the egg problem. In economics, we call it the endogeneity problem. It’s really are exports causing growth, or is growth causing exports, or productivity causing exports or exports causing productivity?

There is always this challenge. This Khandelwal paper from the QJE 2017 I think was fantastic because they focused on these carpet sellers and carpet manufacturers in Egypt. It’s like a randomized trial. It’s one of the randomized trials that actually I thought was nicely done enough to actually produce something interesting.

RAJAGOPALAN: Because it’s generalizable—

LAHIRI: It’s generalizable, yes.

RAJAGOPALAN: —given the global competition.

LAHIRI: In a nutshell what they did was they picked up some very small-scale carpet makers and selected a few of them randomly to train them about putting them in touch with export markets and telling them a little bit about how to sell. Then they looked at their productivity and what happened with the ones who were not part of this pilot program versus the others who were. There was a massive difference in just three years’ time between the ones who started exporting and the others who were not. This is just pure export-led productivity growth.

That’s the part that productivity was endogenous because they had to do a bunch of things to keep up. Personally, I have a story of a friend of mine who’s a shoe exporter. I always find the story interesting because he got a contract to supply shoes to a big South African retailer. They said, “Why don’t you give us an initial batch of 10,000 shoes. So send us a sample of 500 pairs.” He said, “Okay, we’ll send you a sample.” He said, “Yes, but you have to come with the sample because we are going to do the testing in South Africa in our office.”

This friend of mine and his partner show up there. They say, this is like a whole different ballgame because they’re loading shoes. It’s a conveyor belt, which is the sample testing. These 500 shoes are loaded up. The pairs are coming through on a conveyor belt. There are five or six stations where each station is manned by one person who’s checking one aspect of the shoe. At any point, if there’s a failure the thing gets tossed. Their failure rate was apparently 40%. That was the first batch. They, of course, coming from our local sensitivities, tried all the Indian ways, going up to the people manning the stations to see if some bribery would work or something else would work.

Everything just kept making it worse. Finally, they just begged and pleaded saying, “we understand. Forget about this. We’ll send another sample back to you. Just give us one more try.” They came back. Of course, these guys were basically getting their shoes made from Agra. They had their own supply. They said, we’re going to do the same thing. They started putting in this whole testing scheme in their Okhla office. These Agra guys were now faced with 50% failure rates.

Now he’s regularly exporting around the world. That is something that spreads because this is due to having to compete outside. It’s like anybody who is in that business, who knows it, will also pick up on the fact that this is how you organize your production line. There is a huge amount of learning by doing which spreads. These are best practices, global best practices spreading, through just the process of engaging with global businesses. If you don’t, you’re never going to pick up. That is in a nutshell, I think, the thing that exports bring for you. 

RAJAGOPALAN: That’s a great example. On this, now, I want to get into the labor side of it because that’s the second half of your argument. Here, Devashish, you have a very nice paper, your REStat paper with Hasan and Ramaswamy, where you look at labor elasticities and their inverse relationship with the level of protectionism.

MITRA: Yes.

RAJAGOPALAN: One, you do that at the overall trade level. Then you also look at it, if I remember correctly, at the state level, right? The states that are a little bit more flexible and pro-employer and pro-business versus those that are a little bit more rigid in their regulatory impact. What you find is, one, that the elasticity is inverse. The more protectionist you are, the more it’s going to hurt when it comes to firm-level hiring. Then second, if you do manage to reform the protectionism part, then if you reform the labor part, it’s going to have an even bigger downstream effect. That’s how I understood the bare bones of your paper. Is that a good way of thinking about it?

MITRA: Yes, it is. There’s basically an interaction effect between the two.

RAJAGOPALAN: What is the mechanism of that interaction effect? Is this just something that happened in India because India is such a labor-surplus economy? Or is there something more fundamental in the relationship between trade protectionism and labor elasticity in that there’s something about competition and economies of scale when it increases all the other productivity and capital utilization levels, it’ll also increase the number of people employed? What’s a good way to think through that question?

MITRA: Labor is both a state subject as well as a central subject in India. To the central laws, the states can make amendments. Some states have made more amendments than others. Also, the implementation of the laws will vary across states quite a bit, the monitoring. Some states have very rigid laws in the sense that the laws result in a lot of rigidity in terms of labor adjustments. You’re not allowed to fire workers easily. Some states might be more lax about that, and they’re very strict about not allowing you to reassign workers to other tasks and so on.

When that happens, you’re automatically constrained. Through trade, what happens is that more trade basically means that you’ll have to do some kind of moving labor from one task to another. Or if the demand for your product shrinks, you may have to fire some workers. There will be some labor retrenchment. That is coming from the trade liberalization, the extent of that happening is constrained by these regulations. It’s pretty straightforward.

RAJAGOPALAN: At one, I understand that the interaction is straightforward, but is choosing whether someone’s going to be in a more flexible state where it’s easier to hire workers, is that endogenous to create protectionism to start with, or that’s not a good way to think about it?

MITRA: That’s not something we actually investigated. We thought that the time period we had, we just took their locations as given. You raise an important point about the location of firms based on labor market rigidity. That basically probably didn’t happen because it’s not clear whether the rankings of the states in terms of labor market flexibility or labor market rigidity would be preserved. It’s not a thing that firms can keep locating and relocating their production plants. They have to make a long-term decision. We took that location as given.

Manufacturing-Led or Services-Led Growth Model? 

RAJAGOPALAN: Now, coming back to the paper, the core argument as you’ve walked us through it is India needs to grow. India needs to grow much faster than it’s been growing so far. Added to that is there’s this enormous demographic dividend. Lots of young people who are desperate to find jobs. We of course have a skilling problem. They’re not very highly educated. Even though we’ve democratized education and they have some basic level education, they can’t exactly become software engineers, but they do need to exit the farm sector and the agricultural sector.

The way to solve this problem is through manufacturing. The only way you can really get the manufacturing going is if it is export-led, and it is merchandise export-led. That’s the core of the argument. Now, this would’ve been totally uncontroversial a few years ago. This was just the consensus and the orthodoxy. Now that seems to have changed a little bit. You have folks like, Dani Rodrik—that Devashish, you worked with before—who have argued that the geopolitics have shifted quite a bit.

The kinds of things that are being produced and exported, the level of technology that has been introduced into even very simple merchandising is now at a different level, so that old model of making shoelaces cheaper than the neighboring country or the neighboring firm, and then exporting and that leads to growth and employment, doesn’t exactly work quite the same way.

Then you have for the India-specific example, most recently you have Raghuram Rajan and Rohit Lamba who’ve talked about how, in addition to the geopolitics in India, the growth trajectory has been a little bit different because of English speaking and the IT sector boom. They’re really focused on the smile curve, and how we can think about the high-end service sector, which is where India should focus its policy efforts. That’s where we should root the growth aspirations. Why are you still sticking to the orthodoxy? What has changed and why do you disagree with this new thinking?

LAHIRI: The way we look at Raghu and Rohit’s take, at least that’s how I view it, I don’t want to put words in Devashish’s mouth, but that perspective of trying to zero in on the high value-added ends of the smile curve, I think is more like a medium- to long-run goal. That, it requires the level of human capital that is involved with either the design stage of products or is involved with the distribution stage of products. So that’s the service interface really with manufacturing. That requires a level of human capital, which given the current reality of India, we just find this completely incongruous, as to how you can accommodate 10 million additional people a year at the levels of education that they’re coming out with. Where even engineers—we are producing STEM graduates, maybe 30% of them are viewed as employable. The rest are not. 

This is just incongruous to us as to how you can imagine us investing. As a goal for 2050, yes, but that requires a different kind of goal too, and you don’t require a state-led initiative for that. All you need to do is incentivize human-capital training, and the education sector has to become a core. If enough people are coming out from that, the system will automatically create that. Where there is a need for some kind of state-led policy is to try and accommodate people with their current skills into what is going to provide them with a significantly better outcome than what they’re getting now. That is the challenge. Yes, if you start investing in human capital, it’s going to take 20 years for you to produce people who are coming out who can then start adding value to the two ends of the smile curve.

I think that’s a fine chart. We have nothing against that. I think that that makes a lot of sense. It has to be, and maybe one way to recast what they are saying and what we are saying is that, you need to focus on the long term through investments in the education sector, and then it will automatically start moving toward the two ends. Right now, you have to incentivize the manufacturing because that’s where the skill levels, the ones that pick up, we don’t really want people to move from agriculture to a somewhat slightly better world as a gig worker. Even that is challengeable as I think the pandemic reverse migration showed. 

What the current economy is producing for fresh participants in the labor market is nothing really fundamentally better than what they could do just by being underemployed and overpopulated in a rural agricultural sector. I think that is the challenge, to produce a significantly improved quality of life for a whole bunch of people who are now significantly better educated than their parents were, and yet are not quite at the level where they can be profitably employed in high-end services.

Without making that bridge, to say that we are just giving up on manufacturing, I think is creating conditions for serious social disruption because this is where, again, I come back to that aspiration. It really worries me that you cannot have a massive set. Over the next 10 years, you’re going to produce another 100 million people. The population itself is, we are talking about 700 million people under the age of 30. This is a huge number to be unhappy with the way things are going. 

I think the way I want to bridge these two views is one, I view as really a cry-out for investments in the education sector, which, because it’s a long-term goal, and really, as I said, it doesn’t need state intervention to do that. You have to prioritize the education sector and then it’s going to take care of itself as people go off, unless the state starts getting in the way of people saying, “you can’t do this or you can’t do that.” The rest as the challenge now is to employ people who are coming out now. That’s where manufacturing I think is key. Maybe Devashish has a different view.

MITRA: If you just focus on the two ends of the smile curve, then you can employ a few people, but that’s hardly going make a dent in the jobs problem. Then you look at basically all the people that, as Amartya mentioned, they have all these B.A. and B.Sc. degrees, and they just don’t have the skills to be employed. On top of that, if you look at the people with secondary school education, and there you can look at Karthik’s work, Karthik Muralidharan’s work, or you can look at the ASER reports, eighth-grade students don’t have the second-grade or third-grade writing and math skills.

That’s the reality of the situation. You cannot employ these people at the two ends of the smile curve. How do you get to the level where everyone can be employed at the two ends of the smile curve? It’s going to take a lot of time to make that transition. The other thing is that there’s some empirical work by Veeramani and his co-authors, where they actually find that if you actually are part of the global value chain and you are basically doing the production work, then the volume that you’re exporting, that more than makes up for the low value-added per unit.

I think that work is really important because it’s empirical evidence that this is the kind of thing that works. That is, you locate within the global value chain, and then you have whatever skills you have, and how do they match up to the smile curve? They can locate themselves in the central part of the smile curve where the value-added per unit is low. You more than make up for it through volume. As Amartya said, a long-term goal could be that we contribute a lot to the two ends of the smile curve, and in the short run we have some people who can contribute to the two ends of the smile curve.

How do you actually educate people who have secondary education, but their reading skills and math skills are at the lower end of primary education? How do you put them at the two ends of the smile curve? It’s just impossible. That’s why we believe that labor-intensive manufacturing, but within the global supply chain might be the way to go. We agree with Dani Rodrik that you don’t have the kind of manufacturing that you had earlier, that all of it is being done within a particular location. There are parts of this global value chain that can be located within India given the skill levels we have.

In fact, what it does is that the lot of products that are overall capital-intensive, but there are some labor-intensive components. It gives us a wider range of activities which can employ the low-skill labor that India has right now. Goods that are overall labor intensive, there, you can employ them. Also, in overall capital-intensive production, you can employ them for the more labor-intensive tasks. The fact that you have this international fragmentation of production actually helps India and doesn’t hurt. I actually disagree with people like Dani Rodrik on that. It’s not limiting our choices, it’s actually expanding our choices.

RAJAGOPALAN: Just to play devil’s advocate for a second, the way I understand Raghu and Rohit’s argument is not so much that we give up on manufacturing, but that the new push that the government seems to have is through PLI schemes. You spend billions of dollars with these production-linked incentives, you put them toward electronics assembly or semiconductor chip manufacturing assembly and so on. The idea that that money would be better spent if you can 100x the R&D either through the IITs or the IISEs and so on.

There’s a subpart to their argument. To be fair to them, they don’t want to completely give up on manufacturing, so to speak. Now that we add this idea of, okay, there’s a government that is going to spend, let’s say, $10 billion or $15 billion on a particular production linked scheme, does that change how you think about it? Or do you think that the idea of manufacturing-led growth still holds, and these kinds of schemes are the way to go to start some green shoots in certain sectors? Or some third answer which is completely different like just do trade liberalization, you don’t have to do any of this?

LAHIRI: No, I don’t think we disagree with the fact that the characterization of these PLI schemes being fundamentally problematic in the sense that you’re giving a lot for relatively low. The challenge for the economy is to produce not just high GDP, but to actually produce high value-added jobs at the same time. The production, I think, they have excellent examples of showing why this can be completely gamed without creating any real jobs. In fact, it’s almost like a transfer in certain cases if people really wanted to game it, where you just assemble and ship things out, and you qualify for all the incentive payouts.

The bigger thing is where these sorts of schemes are probably also problematic is that—I think the current new policies seem to be redressing or change focusing on that. That if these were rather employment-based incentives as opposed to—the fact of the matter is we now have to play with WTO rules. We cannot do the East Asian strategy. We can’t say that it’s all going to be export incentives and so on, because all of those would get slapped on right away. Hence, we have to find other ways.

Now for some reason, they chose to go the PLI route, the production-based route, which has this very obvious way of not satisfying the main goal for why you want to set these things up. At the end of the day, you have to use your people. One of the biggest resources are the people. You can’t just think of what’s being produced without thinking of how are you using your people to produce it? Employment-linked incentives would be potentially one way of trying to incentivize and create channels of investment that can pick up steam.

Again, training starts kicking in once people start coming in and if they are employing people in sizeable numbers. That probably is not a bad way to go. You raised this earlier about Dani Rodrik’s critique. Baldwin has a similar kind of critique as well that the nature of global production has changed so much that this idea that you can have old ways of producing is all gone and you can’t see shop floors, and you can barely see a human being. That’s how a lot of the international conglomerates are producing now.

That is, again, reflecting a little bit on what the labor market conditions are. Firms are going to choose what technology they use based on which is the cheapest factor. If you have labor becoming more and more expensive, you will find an endogenous movement toward more and more automation. It can happen if labor becomes either more expensive or labor laws are so tough that they don’t want to deal with them. All of those things will create exactly this. They’ll create a much greater capital interface, technology interface and trying to minimize exposure to labor.

This is where policy has to be focused on incentivizing firms to employ people without worrying about getting trapped with people and not having any maneuver to move. This is the same thing that applies in the U.S. when people are complaining, that if Trump tariffs go in, are these businesses going to come back to the U.S.? No, they’re probably going to go to Mexico, not to the U.S. because that’s where labor is cheaper. Firms are going to optimize based on the cost of production. Whichever factor is the most expensive, they’re going to minimize their exposure to that.

If labor is your biggest resource, it is your cheapest factor. If you incentivize firms to use your cheapest factor, they will use them. They will not start investing in machines if they can get stuff. That’s the reason why textile industry in Bangladesh uses a huge amount of people, so it’s very labor intensive. That’s just the reality of it. I think trying to figure out policies that incentivize use of your cheapest resource, and this is the ultimate story of trade or comparative advantage is what that message is.

Somehow we keep missing that, that you’re looking at your people, they’re all over the place. It’s hard to miss people in India. Yet, the policies are somehow there is a Band-Aid here, there is a Band-Aid there, which is all about the state trying to help people in trouble. At the end of the day, we have to get beyond that. We have to get to the point where the state shouldn’t be trying to help people in trouble, but rather trying to create conditions for growth of their prospects, which is about trying to get firms to not worry about employing people. That’s where our thrust of our argument is really that, that that’s where we need to go.

MITRA: I think what Amartya effectively is saying is that this PLI or ELI, employment linked incentives, these can’t be a substitute for things like skilling and other kinds of reforms like labor reforms, land acquisition reforms and so on. As you said, these are Band-Aid solutions. They’re not going to work forever. These firms have to have an incentive to hire those workers. You just bring them in, they enjoy these subsidies for a couple of years and then they go back. I wouldn’t go that far, like what Raghu and Rohit are saying, but there might be things like they come in, they get some information by coming in. There might be some industries where workers have great skills or some aspects where workers have great skills, so they get that information through it. Some might go back. 

The other thing is that these are sunk costs that they’re incurring. Once you incur the sunk cost, you can keep continuing. I think there is a logical flaw in what Raghu and Rohit are saying. It’s not a cost that you have to keep incurring and not all the costs are annual costs. There are these one-time costs, and to the extent they get help from the government on those one-time costs, and those are sunk costs, they might continue and they might extract some useful information, and some of them might stay on.

Scaling Manufacturing

RAJAGOPALAN: On PLIs, my worry is the same as the ones that you probably have, which is, is there an eclipse clause to this? It’s the same with infant industries. It’s like a country of 80-year-old infants that never seem to mature and grow up. Will these always be these hobbled industries that need crutches, or can we one day start eclipsing these, and these were just the sunk costs or the startup costs that were there to incentivize someone to come and then they start going away?

My bigger issue actually with what Raghu and Rohit said, and I talked with Rohit about this, is there seems to be a suggestion that if we spend the same amount of money and resources and everything, and throw it toward high-end education—we already have a lot of momentum with IITs and STEM graduates—and if we just try and make that better, throw all the money at that problem and get that going, that it’s actually scalable. 

I was recently reading John List’s work on the voltage effect and the voltage drop. This is a really big problem when it comes to higher-end education. To produce 1,500 more graduates, you need 10 more physics professors, which means to produce the millions of STEM graduates, you need about 1,500 physics professors. We need to go back in time 10 years to produce those 1,500 physics professors so that they can start today. If we scale from 100 physics professors to 1,500 or to 15,000, are they going to be the same quality anymore? It’s that question of how do you scale this without losing that quality. Will you have that voltage drop? 

Somehow in manufacturing, we’ve seen that the scaling and the voltage effect works. There isn’t a voltage drop. In fact, what tends to happen is if you start scaling in, say, shoelaces, then the building next to you or the warehouse next to you starts scaling in shoes, and then the warehouse next to that starts scaling in socks. I think this is something that we seem to have forgotten, and there’s a tendency to bring the learnings from agriculture and just import it into industry or from industry and import it into services, as if all these are similar. That worries me a little bit.

MITRA: I think scaling has become a bit easier now with this online component in education and so on. There are all these remote parts of India. You could actually enhance the quality of education by adding an online component. Normally holding other things equal, I think in-person education is better than online, but other things are not equal in this case.

You can enhance and scale up education a bit using certain online components, but you are right. It’s going to take time. It’s not going to be like you throw money at it but in this case, money is not going to be time. You need both time and money. You have to wait for the next generation of workers. It’s not going to happen with the current generation of workers or it’s going to take at least a decade and a half, I think.

RAJAGOPALAN: The second part, and I want to pick your brain on this, is that you know the two ends of the smile curve. The idea is that one can specialize in the top ends of the smile curve by bypassing the manufacturing route. But that seems to presume that there is no learning in the manufacturing route that gets you to the top end of the smile curve to begin with. If we think about what’s happening in the U.S. right now, maybe that’s the lesson that we get, because so much of the manufacturing has been outsourced. They haven’t manufactured a chip or a phone in so many decades.

Yet they are managing to design the top end of those things. They’re on both top ends of the smile curve. If we look at South Korea, they got to the top end of the smile curve based on what they learned. First, they were just doing cheap knockoffs and imitation. Then they actually went up the manufacturing curve, then they went up the R&D curve, then they started creating their own IPs. Now they’re very much in the design function, and they may even be outsourcing the manufacturing to a cheaper place like Vietnam or somewhere else.

Can a country bypass the manufacturing stage to even get to the top end of the smile curve? That would be my second question. Or is it going to be one of those things where universities teach whatever they teach and it has nothing to do with manufacturing R&D and what is actually useful and applicable going from academia to the lab, to the factory firm, to the warehouse, to the export?

LAHIRI: That’s a good point. Can you even climb a ladder without actually being on the bottom rung at some point? It’s like what exactly is useful, what exactly is not? At some level, you need these backwards and forwards linkages. That part is true. However, I think the more globalized things get, I think there is this aspect that if you’re part of a global value chain, you start learning more just off the process that you’re involved with. More gets transmitted than if you were working in isolation. That probably is the idea that even though I’m doing some production, but I know that I’m passing it on to someone.

This is where they said, do you need state intervention to incentivize high-end service sector interfaces with businesses or that will happen automatically if you have well-trained people? Our service sector, the IT-based service sector, was not led by the government. It actually was because the government got out of the way saying, “you guys do what you want.” People figured out where the value-added was. If you have sufficient numbers of trained people, they will look for value-added where it exists, but these people need to be able to run.

There is something to what you say that if you’re not fully aware of the entire value chain, and so we all have examples of industrialists who send their kids to work on the shop floor. The Bajaj’s do that and so on saying you got to work for a few years on each shop floor and only then do you come up to the board because you need to know the whole back end, front end and the middle. There is something to that. I think the process of globalization probably—

RAJAGOPALAN: Diffused that, yes.

LAHIRI: —diffused that process. The way I see it, that top end is really something that does not require a state-led interface. This whole thing of individuals will do it if you just allow them to have the tools to access that, and our IT service sector is the best example of that.

MITRA: Let’s for a moment think that Raghu and Rohit are right and we should just focus on the two extremes of the value chain. Then the same advice should be valid to all countries at India’s stage of development. Then who’s going to do the middle part of the value chain? That’ll be missing totally or what? That’s the question I have, right?

RAJAGOPALAN: My question is actually even more complicated than that. It is that Kerala’s GDP per capita is like Morocco and Ukraine and closer to that end of things. Bihar’s GDP per capita is closer to the sub-Saharan Africa.  

Why aren’t we saying that Kerala or Karnataka can do the top end of the smile chain, and we still have places in India which can do the bottom or the middle of that chain? We haven’t managed to integrate domestically, let alone integrate with the rest of the world. I think I have that problem in addition to what Devashish is saying, which is, “Someone has to do it.” But if someone has to do it, why can’t it be people in Bihar?

LAHIRI: No, totally. Completely. It comes back to this original question you asked about endogenous choices of firm location. Where a firm’s locating, where is the investment going? This is where I think some of the lessons should be clear that if you set up incredibly business-unfriendly environments, very, very protective labor environments, you’re going to end up with choking off the spigot coming your way. That doesn’t help the education side either.

It’s not like if you choke this off, people start getting very educated. No. Because the state has no money to fund anything at that point. There’s a reason why India’s education expenditure, even if you’re spending under 2% on education but you’re spending huge amounts on just welfare schemes of free food and so on, that’s not investing in people. It’s investing in Band-Aids.

That’s where I think there has to be a fundamental reorientation of the policy focus. It has to be trying to invest in people not in transferring stuff to entity A or entity B. It’s very difficult to get out of this mindset politically, I think because we are in a world of competitive socialism. At least in the Indian political structure, that’s what it is. Competitive populism, I think most elections are like that. Each party tries to outdo the other, and that’s just a bad equilibrium.

I don’t know how one gets out of that, but if one has a big enough political mandate, an electoral mandate as and when a party gets it, it shouldn’t waste it. Because that’s when you can break through a little bit. Hopefully, it’s going to happen. We are still stuck with trying to provide Band-Aids and not investing in people in some sense.

MITRA: I think the problem with investing in people is that the returns take time to be realized. When you are in a system where every few months, you have some kind of an election, it’s not a very lucrative thing for politicians to push for investing in people. Because you might see the returns in a few years. I think the political system doesn’t lead to incentives for investing in people, I think.

RAJAGOPALAN: Yes and no, Devashish. I think you’re absolutely right if we talk about the spending and the investment coming at the union level or the state level. If we dramatically fiscally federalize and we say that health and expenditure will all be taken care of at the most local level, then you do see the returns within an election cycle. All of us live in North America, and you see the kind of craziness that happens with electing the school board, the local mayor and so on.

Five years in your child’s life is the difference between being a factory worker and being a rocket scientist if you’re in the wrong school and in the wrong school district and things are going badly, and they stopped teaching math and all sorts of things that are happening. I don’t know. There’s a whole issue in Virginia districts about math being racist, and we need to dilute the levels of math. Every Indian family I know is now going to learn Russian math. There are these Russian math tutors.

I asked my niece, I said, “What is Russian math?” She said, “It’s regular math with a Russian accent.” I said, “Okay. I understand well what’s happening out here.” I think you are right. I think it’s also that we’ve overly centralized everything, which means the fertilizer subsidy or the loan waiver will give you the immediate vote, whereas investing in education is never going to be seen at the union level. 

Labor Productivity in India

I want to go back to one interesting section of your paper. This is where you are comparing labor productivity of workers in industry, and you’re looking at the comparison between China, Bangladesh, India and Vietnam. You look at GDP per worker, value-added per worker and so on. One of the things that you point out is that labor productivity within industry in India is the same as labor productivity in Vietnam despite the fact that the average Indian worker has many grades lower level of skill than the average worker in Vietnam, which has actually done an extraordinary job with its education. My question is, what exactly is going on here?

Is it that the middle of that curve is such that it can accommodate everyone at any skill level and it’s the production process and the export-led pressure or competition that manages to get the most out of those workers? Or is there something else going on that despite the differences in skill, Indian and Vietnamese workers end up being at about the same level of labor productivity?

LAHIRI: It’s one of those cases where you get totally surprised by it. This is something that we found. I don’t know. I think it’s the first thing that you said. I think that middle is broad enough that it accommodates a huge variety of people in there. As long as you localize in that kind of activity, it’s called convexifying in some sense. It’s like you convexify all the various skills into one and that’s basically what you just said. I think it’s partly what’s going on. As an individual firm, you can choose various points in that middle. Once you convexify over the whole thing, you’ll end up possibly—well, it is not true for China, for example, in that same picture labor productivity in China—

RAJAGOPALAN: China kind of takes off.

LAHIRI: China kind of takes off. Up until a certain point. I think, the long and short of it was while all of these skill issues apply at the two ends, which is where Raghu and Rohit were focusing, but for manufacturing, that skill deficiency is not necessarily a big problem. 

RAJAGOPALAN: It’s not binding.

LAHIRI: I think it is not a binding constraint for manufacturing at that level. It’s not like we can’t compete. We can compete. Our guys are okay. Based on the other places that typically one would think of as a firm, an international firm was trying to figure out, should I locate in Vietnam? Should I locate in India? Should I locate in Bangladesh? Labor productivity should not be an issue. It’s independent of what levels of education they have or they don’t. Even the Vietnamese are more educated. You’re pretty much going to get the same thing. 

RAJAGOPALAN: It’s a light bulb moment. I had to go back and read that sentence three times in your paper. I was like, “This can’t be right.” Then I was carefully going over the graphs and circling the different color countries.

LAHIRI: No, it was very striking. It was incredibly striking. That also is uplifting, at some level as a very hopeful thing that it’s not like we are constrained by some history that we are stuck with a bunch of people that we just can’t compete. We can compete even despite the fact that our labor is not as educated or as skilled as the Vietnamese typical worker is, but at least in that middle, we can still work it. 

This actually also brings up this other issue that we do flag in the paper. The biggest difference, I think, in terms of per capita incomes, then if productivity is the same, is the female labor force participation. We are just wasting a huge amount of people. Even if you account for the fact that maybe some part of those people who are not working are not at the same levels of productivity and so on, but nevertheless, our per capita incomes would be a whole lot higher if we actually got these people to work. This is where the gender imbalance in the labor force is a hugely debilitating thing.

That’s the other part of public policy, I think, that has to really get focused in with a laser-like focus, that we have to get that 50% of our workforce and we are wasting more than 50% of that workforce. Nobody’s showing up and that is a wasted resource. We just have to get women to come out to work. And this is I think where policies might become important about how you incentivize, because it’s a culture issue as well. Whether women come out to work or not has a huge cultural aspect.

RAJAGOPALAN: The more I dig into that literature, the more I’m realizing I’m more on the Ashwini Deshpande side of this, which is that when there is an increase in demand for labor, female labor force participation increases. In Tamil Nadu, you have high female labor force participation. It’s no coincidence that it’s also our more industrialized sector. It has special economic zones, it has more flexible labor laws. That’s where all your Foxconn and Qualcomm and everyone wants to locate.

When they do want to move there, they want to hire women. Because women actually have very strong core skills and require very little instruction and training, relative to say teenage boys or young 20-something boys of the same age. I feel like I don’t even know if we need very specific female-led incentives or policies except basic law and order and some kind of rule of law. I think as long as the demand is there, it’ll take care of itself. I don’t think of Indian women has any more exotic than Vietnamese women or South Korean women or Chinese women, culturally. I think all of them have the same pathology and we have the same pathology.

MITRA: Female labor force participation has been going down over time in India. That’s the other puzzle. Why are we seeing a decline in female labor force participation? While in Vietnam, especially after they signed the BTA with the U.S., you see a higher proportion of women going into work, especially in manufacturing. 

Of course, it brings us back to trade. Vietnam has bilateral trade agreement with the U.S. which has helped them with their exports, with foreign direct investment and so on. India struggling to sign BTAs and managed to sign one with UAE and one with Australia. These foreign firms, actually, they come and they want to hire women. You’re right about it. 

Rising Protectionism 

RAJAGOPALAN: To go back to your paper, since you say that the entire mechanism for you starts with this export sector-led manufacturing growth, the key to that is reducing protectionism. Now, there are multiple things going on. One, of course, in India, protectionism is rising, which is quite alarming.

A lot of the gains and a lot of the consensus that was built in that liberalization moment, which continued for about 15, 20 years, and now, there’s a bit of a U-turn. In general, tariff levels are going up, most favored nation tariffs are going up. Then a second aspect of that is the tariff inversion, the import substitution. All the crazy policies that we had originally agreed are very, very bad ideas, somehow seem to be working their way back into the mix. The first part of the question is, what’s going on in Indian manufacturing that this seems to be the new consensus?

Is it a new consensus or is it just good old school political economy cronyism that’s now found its way back into trade tariffs? Or is there some method to this madness that India has decided that there are going to be certain tariffs lines that are going to be open for certain sectors that it wants to focus in? I’m just missing something that trade experts can see.

MITRA: I haven’t looked at the new budget in detail, but from the short reports that I’ve read, apparently they’ve reduced tariffs on a number of things this time. They’ve said that they’re going to do away with tariff inversion, they made a clear statement. Of course, they don’t think it’s a good idea to keep increasing tariffs. It’s pretty clear. It’s one way of admitting their mistake. I don’t know what happened.

There is a little bit of cronyism there as well because there are all these big business houses that probably want some protection. But I don’t think they think it’s a good idea because there are lots of things on which they have actually reduced customs duties in the new budget. 

LAHIRI: I think this government also has been extremely sensitive to fiscal targets. 

RAJAGOPALAN: They want to use tariff revenue to plug their hole. Oh, my God.

LAHIRI: Everytime they’re looking for funds… This is a conjecture but they’re very fiscally aware. 

RAJAGOPALAN: They’re very fiscally prudent.

MITRA: I wouldn’t call it prudent. 

RAJAGOPALAN: No, they’re prudent. They’re trying to be prudent in the sense they don’t want to run huge deficits and things like that.

LAHIRI: They’re very concerned about the fiscal deficits. This has taken various forms whether it’s trying to move money from the right hand to the left hand within the public sector to try and keep the overall deficit down. Another part is they’ve been looking for revenues or trying to get the RBI to make bigger transfers. There’s the other part which is also working for this toward the same end. At least I think some of the increases post 2015 were looking for ways to create more fiscal space.

RAJAGOPALAN: I thought we had 200 years of consensus on this. That is not a good idea. Do you know what is the advice they are receiving?

LAHIRI: Yes, that has been a big mystery on the advice.

RAJAGOPALAN: Because this baffles me even more than the cronyism thing. That, I understand. I’m like, “Okay, there are business houses which want protection and so on and so forth.” The idea that you use trade tariff revenues and custom duties to get fiscal space is so out there and crazy to me, I can’t even believe it.

LAHIRI: Yes. Here, there is this our professor, Arvind Panagariya. 

Arvind has this idea that oftentimes what ends up happening is what is the advice space. He thinks it’s bureaucrats often take up the advisory space and bureaucrats often work off old playbooks. Give me some quick solution. The easy solution to something that is like, “Okay, we’ll revisit in a year’s time,” or something like that but we need some way of plugging this hole or that hole.

Old playbooks are often dusted off in those moments to provide easy solutions. That can lead to outcomes. That has been his sense. Why are they increasing? There’s, of course, also this idea that we are playing—

RAJAGOPALAN: He’s in the next building. They could just ring him.

LAHIRI: This was happening when he was in the NITI Aayog. It is not like this is later.

RAJAGOPALAN: It is crazy.

LAHIRI: I think part of it is also the fact that there is this constituency that believes that industrial policy is the way to go. That’s the other part of it. The industrial policy is trying to recreate the Asian model 30 years later even though the world has changed, but 30 years later, maybe we can induce this domestic industrial policy which creates domestic demand that is sufficiently high. Of course, they missed the other part of it, which is that the export side of that model.

RAJAGOPALAN: Exactly.

LAHIRI: That is now not WTO compliant anymore. You can’t take one part of a strategy when you can’t do the other part of the strategy and that just doesn’t work. 

RAJAGOPALAN: Because they lost the disciplining mechanism, right?

LAHIRI: Yes, you lost the disciplining mechanism. This is an old playbook, where the game has changed, and you can’t quite do the whole play. You’ve just taken one play, but the game has changed so you can’t quite do it. That, I think, is an inconsistency that maybe they’re belatedly recognizing that that doesn’t work.

RAJAGOPALAN: Yes, there’s always hope. Devashish, you look depressed when it comes to raising revenues through tariffs. I think this is the saddest I have seen you look in the last 90 minutes.

LAHIRI: That, by the way, is a conjecture about it.

RAJAGOPALAN: Yes, I understand. We don’t have good information on this. Yes.

MITRA: I think there was some work where it showed that as countries develop, initially, they have high tariffs because they depend on tariffs for their revenues. Then at some point in time, they developed enough that they can raise enough direct tax revenues that they create this kind of IRS that can collect income taxes and then they reduce their dependence on tariffs. I think there was a model like that with some empirical evidence—I don’t remember—that I’d seen a long time ago, but it doesn’t seem to apply to India.

India’s economic size is several folds what it was 30 years ago, and then it’s reverting back to tariffs. That kind of revenue argument doesn’t make sense at this stage in India’s development.

RAJAGOPALAN: One thing that you didn’t get into too deeply because we have Arvind and your other colleague, Pravin Krishna, writing about trade specific to bilateral trade agreements and when it comes to unilaterally reducing tariffs. Where are you on this? Do you think the Indian state can do this tinkering business that it has been in for a long time, which is sector by sector, go in and tinker with tariffs a little bit and talk and consult?

Or do you think, at some point, we got to go to the old way of just uniformly reduced tariffs, bring them up to a point, it’s never going to be perfect, but it will eliminate uncertainty, it will eliminate this cronyism and then we can better integrate into global supply chains because now people have certainty on what their cost structure looks like?

LAHIRI: Yes. I think the uniform tariff, that seems like the least distortionary way of doing things. The most transparent. The least distortionary and the most transparent. Those are the two things that you need in any tax policy. You don’t want to have any signs of arbitrariness and you don’t want to have uncertainty surrounding it. Also, this whole thing of retroactively going back and readjusting things.

I think this uniform reduction would be the least distortionary way of doing it. I think activist policymaking often has delusions of grandeur about what amazing things we can do because we’ve been blessed by extra insights that nobody else has. That’s a danger that policymakers should keep away from. 

I forget which president it was. There was one U.S. president who had a great line that ‘policymaking is all about facing boulders coming down the hill and getting out of the way.’ Basically pick the one boulder that you may want to get in the way of, but the rest of it is just getting out of the way. That, I think, is something that policymakers should pay more attention to, that it’s really the less interventionist you get, the less you are liable to make errors. People, on average, know where to go looking for value, and they will just get out of the way. 

RAJAGOPALAN: My favorite is the Hayek quote, “The curious task of economics is to demonstrate to men how little they know about what they imagine they can design.” I think that’s where I am with the bureaucrats on the tinkering versus having this uniform rate. Devashish?

MITRA: Yes. I’ve always been against distorting relative prices. Then you have like man-made relative prices, like policymakers actually making relative prices, right? Rather than relative prices being determined in the market. The moment you have like these are tariffs that are not uniform, then you’re basically distorting relative prices. These relative prices are artificial. It makes me feel that you are in a command-and-control economy rather than in a market economy. As we know, that cannot really work. I’m all for uniform tariffs, but at a very low level.

RAJAGOPALAN: Yes, single-digit low uniform tariffs.

MITRA: Can’t be like 50% uniform tariffs. That wouldn’t really help. Then you’re creating this huge distortion between importables and nontradables and stuff like that, right? Keep the distortions to the lowest possible level, maximize efficiency and then think about distributing the bigger pie that you’ve created.

RAJAGOPALAN: Yes. Other than trade, in your paper, you talk about other things India needs to do, for instance, labor reforms. Kadambari and I are writing about it actually in the same series. I think it will be out by the time your episode airs. Our argument is on labor reforms. One is, of course, we need to get rid of the whole damn suite of regulation because it’s so bad. Let’s say we’re not able to get rid of it, right? Because there are all these unions and all these transitional gains traps and so on, I would say increase the thresholds at where they kick in.

Right now, most labor regulation kicks in at 10 workers, which is ludicrous. When you see the empirical literature on this, there’s all those regression discontinuity design papers. It just drops off the cliff between nine and 11, right? That’s the impact of how labor cost increasing it is. Our argument is, okay, let’s say for some reason you think it’s valuable for the government to regulate the kind of paint or whether you have spittoons—it’s my new favorite word, spittoons—in every corner because of the Factories Act or something, at least start it at 1,000 workers, so that firms get some breathing room to grow before you crush them with this overwhelming amount of regulation.

Indian regulation is, of course, too much, but I think it’s also too soon. I would say that the second-best reform solution I would accept is at least to increase the thresholds that can hopefully be done at the state level because it doesn’t conflict with the union law. The states can start increasing the thresholds and just get the presidential approval for it. That would be the idea.

Monetary Policy and Trade Policy

On labor law, we agree. I would encourage everyone to read the paper. The last piece of the puzzle I want to pick your brain on, which is not in the paper, is how do you think of monetary policy interacting with trade policy? Since I have Amartya also here. 

MITRA: I know nothing about monetary policy, so it has to be Amartya. 

RAJAGOPALAN: No, because one part that we do forget about the Asian-led miracle and what China did for so many years is they did devalue their currency and kept it at a point where their export competitiveness had an edge. One is, is this something India can do? Is it something it’s already doing? There’s a lot of lobbying pressure to keep the rupee relatively devalued, for the lack of a better term. Where do you think we’re on this and what can be done on the monetary policy front to improve export competitiveness?

LAHIRI: My impression of India’s exchange rate policy has been that it’s a pressure cooker. The way I see this is on average, if you take long enough sweeps, if you actually just used purchasing power parity to predict exchange rates over the long period, so not over one year, six-month period, but you take December 31, 1999, and you said, okay, where should the exchange rate have been based on the inflation differential between India and the U.S. from 1990 to 1999? Now, 2000 to 2024, and the number would give you about 85, and that’s where it is. 

It’s about maybe 83, 84. It’s fluctuating there. It’s not a smooth—it’s more a step function. That’s how India’s exchange rate policy has gone and that’s what the RBI has done, that it holds off. It prevents a secular change year to year reflecting the pressure. It holds off, holds off and then it pushes back and then it’s let’s go. Then you see suddenly it went from 61, 62 to 65, and then there was another pressure. It went 65 to 67 gradually and then jumped to about 71.

Then it stayed there between 70 and 73, 74 for a while and then went to 78. Again, stayed for a while. I think on average, India has maintained competitiveness through its exchange rate policy over at least the medium run by allowing these periodic depreciations of the rupee without trying to prevent it from happening. At some point, it stops preventing it. We’ve had this process of gradual depreciation, which reflects PPP, which is really what competitiveness is all about.

I don’t think the exchange rates has been a major impediment. Should they accelerate the process? I don’t think so. This whole thing is much more orderly the way it is. India, over a long run, has managed to find some sweet spot, where the rupee is not viewed as being a completely unstable currency, and yet, it is not becoming overvalued systematically over time or anything like that. That’s a delicate balance; it’s like a managed float, so to speak. I think it’s worked out okay. For me, the PPP anchor is very important. Are you on average reflecting PPP? Certainly, over a long period, they are.

RAJAGOPALAN: The other part of the monetary policy, which is not so much about the rupee depreciation, is interest rates and interacting with the fiscal, which the government, especially post COVID, has not managed to curb its spending quite as much. The interest rates are relatively high. As a consequence of this, the government’s own debt servicing bill is large and getting larger. On the other side, it ends up crowding out private investment because of relatively high rates. What does that do for export competitiveness?

Because all these firms presumably do need to be able to borrow relatively easily from the market, and if they can’t, that’s when they start lobbying for all these PLI schemes and all these sorts of other things. I imagine there’s no quick fix for this other than just being more prudent, but what is the way to think about this from the trade perspective?

LAHIRI: Well, just in talking of interest rates—and maybe Devashish can get in on the trade side—if you look at the rates being controlled by the RBI, you look at the real counterpart of that, so that’s about 2%. It’s not the real counterpart of it. That’s not that high. Then the question is why are curb rates so much higher? Why are the real effective lending rates so much higher? That reflects not policy, but that reflects the general state of either risk or uncertainty or both or a general sense of productivity being low.

That’s why the effective lending rates are much higher. It probably reflects a combination of all of those things which is not to do with monetary policy. It has a lot to do with the basic economic climate because the real counterpart of the policy isn’t that high. In fact, it’s like, we are running at 4%, 4.5%. This thing is at about 6.5%. We are talking about the real effective policy rate is about 2%. That’s not high by any stretch. 

RAJAGOPALAN: If you’re talking to the same people I am, every single person is complaining when they say private investment rate is lower, they say, “Oh, we can’t easily borrow and we can’t easily invest. That’s why private fixed capital formation is suffering.” My explanation for all that is there’s just too much regime uncertainty and people are not willing to invest in brick-and-mortar.

LAHIRI: I agree, but it’s not due to policy interest rates. This is more a situation which is reflecting economic uncertainty and economic risk. That is not necessarily related to monetary policy. That’s all I was trying to say.

RAJAGOPALAN: Fair.

LAHIRI: I don’t think it’s related to monetary policy. It’s more related to the economic climate, the business environment. The climate is one where there is both risk and uncertainty, and that’s why the spreads—

RAJAGOPALAN: Are so big.

LAHIRI: —over the policy rates are so much bigger. That is a problem that has to be solved from—

RAJAGOPALAN: The top.

LAHIRI: —the top, from the treasury side, not from the market policy side.

MITRA: Is there a system where they are able to evaluate projects and decide whether loans can be given to them or should be given to them or is it like because they don’t have much information, they just decide that they’re not going to give you the loan that you were asking for?

LAHIRI: I have a paper with Urvi Neelakantan in the Richmond Fed. Urvi and I had looked at public sector banks in India and in particular trying to focus on when the nonperforming loans skyrocketed. One of the things that we learned from that project was 75% of all loans go through the public sector banks.

However, when you look at their share of nonperforming assets versus their share of loans, in most sectors, they do as well, if not better, than their private sector compadres. Where the nonperforming loan share is disproportionately greater than the loan share in those industries is in the infrastructure linked sectors. That’s where the whole issue was.

RAJAGOPALAN: When the government gets involved and makes calls and says, “Give it to our friends and our projects,” and so on.

LAHIRI: Exactly. What ends up happening, to answer Devashish’s question, I think when they’re dealing with loans to sectors that are not linked to infrastructure, where they make loans based purely on commercial considerations, they’re doing as well, if not better and they have well-defined mechanisms to actually produce high-quality loans. It is when it becomes linked to the infrastructure sector. The loans are going towards some sector that is linked to infrastructure.

That’s where the nonmarket-based lending begins to kick in, which is, they’re forced to comply with either phone calls coming in or pressure being brought to bear. It’s remarkable that the Indian banks can actually perform. Because effectively what fraction of every rupee can be lent out in an unconstrained way is very small. The government is already telling you that this percent goes to small scale, this percent goes to agriculture, so this is all priority sector lending takes up X%.

Then they have the requirement that you have to invest a certain fraction in this over and beyond to maintain liquidity ratios. You have to go beyond that. You have to maintain some amount in government bonds, which used to be as high as 25% at some point. The room to maneuver for these banks is incredibly small.

That’s why sometimes they just become completely risk averse. Because a lot of their lending, which is the big ticket stuff, which is the infrastructure, gets taken up by the nonmarket-based stuff, which they understand is extremely risky. Then everybody else has to pay. It’s like another part of the crowding out. I think the economic environment, some of this calls into question this whole thing of public sector banks in general that infrastructure investment has been a big thing and public sector banks have traditionally been involved quite hugely in that process.

That has two aspects to it, that the old-fashioned way of financing infrastructure was tax revenues. Once the government goes away from that saying, we tried the PPP route, which led to those NPAs because the quid pro quo was that you come up with a project, you run it for 30 years, and everything and then you give it to me. My part of it is that I’ll give you cheap land, I’ll get you access to preferential lending and all of that. That’s where it got gamed. Now, we have the national champions model of building infrastructure, which—

RAJAGOPALAN: Will end similarly.

LAHIRI: —has a quid pro quo as well. This is the challenge under which the rest of the economy is operating because all of this requires money and big-ticket money. That has to come from somebody else. Every rupee lent to one person is not going to somebody else. 

RAJAGOPALAN: Devashish, you should dust off your old endogenous lobbying paper on trade and I think apply it now to bank lending. Amartya, before you joined the call, I was telling Devashish one of his papers, which is my favorite, is where he talks about endogenous lobbying group formation through political contributions and how that leads to trade protectionism. Basically, that interaction, I think there’s something to be said for that and the national champions now getting money and crowding out private investment by everyone else.

LAHIRI: The national champions are getting money but I think there’s also this big thing about you develop new things and the old developed ones that were done through somebody else or through tax revenues get handed over, so those are already working. There has to be a way. If you want someone to build something for you, you have to give them something. In what form it comes, it could be through cheap credit, it could be just handing over other assets that have been built already.

MITRA: One of the things, going back to your previous question about the interest rates, given the international capital mobility we have, how much control would the RBI have over real interest rates in the end? Not much, right?

LAHIRI: No, our capital mobility is limited. We are completely convertible on the current account, but we are not on the capital account.

RAJAGOPALAN: Not on the capital.

LAHIRI: There is a fair bit, so even for Hindenburg to try and short Adani shares, it was a hugely problematic exercise to try and do that because they have to do a fair bit of that to find domestic guys to do it.

RAJAGOPALAN: Forget Hindenburg, my friends coming from India can’t pay for an American thing online using their credit card, it’s a nightmare.

LAHIRI: Yes, I know it is a nightmare. Long and short of it is we don’t have perfect capital mobility. What we have is very regulated wedge which can be manipulated. It’s not as if India is completely linked to the rest of the world in a one-for-one way that every time U.S. monetary policy changes that there is a transmission of that.

MITRA: There is no transmission of that?

LAHIRI: There is a little bit.

RAJAGOPALAN: There is but a little bit.

LAHIRI: There’s a little bit but nothing like what would happen between the U.S. and Canada, between the U.S. and Europe or anything like that or even between other small developed open economies like Australia, New Zealand and India. Sorry, U.S., in one hand, and countries like Australia and New Zealand, on the other hand, et cetera. Much more closely linked where those guys follow what’s going on in the U.S., maybe the rates get linked.

MITRA: Shruti, you’re talking about lobbying, you’re thinking of lobbying on the interest rate?

RAJAGOPALAN: No. I’m talking about lobbying to get relatively favorable terms on big loans when it comes to these infrastructure projects. The quid pro quo is what you were talking about which is all these political contributions in exchange of which you both get the plum projects but you also need to be able to finance the plum projects and that’s how you get your Vijay Mallya kind of experience, right? That then the state-owned PSUs and so on need to lend to the national champions or at least the political favorites if not the national champions.

That’s the quid pro quo, except unlike trade, we don’t have an opposing group trying to reduce the numbers because the imports are getting more expensive or something. It’s like everyone is going in the same direction trying to extract more risky or better deals from the existing set of public sector banks.

MITRA: You’re saying there are only winners and no losers in this?

LAHIRI: No, the losers are the other side guys. 

RAJAGOPALAN: Yes. I’m saying the losers are the other side and they have a collective action problem. They can’t organize.

MITRA: It’s similar to the tariff, right?

RAJAGOPALAN: Exactly, exactly. Time to dust off that paper, Devashish. You can write another one for what’s happening in banking.

MITRA: Yes.

RAJAGOPALAN: Thank you so much for doing this. This was such a pleasure. Thank you for the paper. We will link to everything and we hope to speak with both of you soon.

MITRA: Thanks.

LAHIRI: Thanks, Shruti. This was a pleasure, absolute pleasure being here again. It was as enjoyable as it was the last time, and it’s always lovely to chat with you anyway.

MITRA: Yes, it was very enjoyable. I learned a lot speaking to you guys as well.