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15.227B Special Seminar in
International Management
Final Class Project:
A Macroeconomic Analysis of the Indian Economy
Joshua Spinak
MIT | Sloan School of Management
India: A Macroeconomic Analysis
India has experienced cathartic growth since it opened its economy in 1991 and
began policies of privatization. Ten percent of the population rose out of poverty in the
period from 1993-2000. Today there is a general feeling of optimism and hope for a
better future. This paper examines the sources of India’s growth and describes the
country’s economy using basic macroeconomic analysis. It illustrates India’s position on
the BBNN and ISLM, and within a framework for understanding transition economies.
Finally, the paper outlines a strategy for continued growth and development.
The Indian BBNN
The BBNN model shows an economy’s real exchange rate, which is the point of
equilibrium between the labor market and the balance of payments. The labor market is
represented by a curve (NN) that includes all of the points in which there is no pressure
on wages to either increase or decrease. This is otherwise known as the natural rate of
unemployment. The balance of payments is represented by a curve (BB) that shows all
the points in which the value of exports is equal to the value of imports. At any of these
points, the economy has neither a current account deficit nor a current account surplus.
Included in the BBNN is an additional curve, called the social peace curve. Social peace
relates the happiness of the populace: if the economy is significantly below the social
peace curve, there will be social unrest. (India’s BBNN is illustrated in figure 1 of the
Labor participation in India is 39% overall, 52% for men and 26% for women.
The majority of the population lives in rural areas, and agriculture employs
approximately two thirds of the labor force while providing for one fourth of the
country’s GDP. India produced a total of 600 million tons of food per year, making it
one of the world’s top producers of food. Manufacturing is responsible for an additional
one fourth of GDP. The services sector, which has seen enormous growth in the last
twenty years, has increased from 12.8% of GDP in 1980 to 48.8% of GDP in 2001.
Population growth and migration from the country to the city both have a
profound effect on the natural rate of unemployment (the NN curve.) India’s population
exceeded 1 billion in March of 2001. Of this population, 742 million people live in the
country. Although population growth is slowing, it is expected to continue until 2030,
when the country’s population will reach 1.5 billion, making it the largest in the world.
Population growth pushes the NN curve outward by increasing the number of workers
looking for jobs. In addition, migration from rural areas to urban areas further pushes the
NN curve to the right by flooding the industrial markets with more potential workers. By
2010, the urban population is expected to comprise one third of the total population. The
immediate effects of population growth and migration are additional unemployment and
pressure on wages to decrease.
In the 50s, 60s, and 70s, the Indian economy grew at a rate of only 3.5%, or 1%
growth in GDP per person, which came to be known as the “Hindu rate of growth.” The
economy picked up as economic reforms were implemented, reaching a high of 7.7% in
1995/1996. In 2002/2003, lower growth of 4.4% was attributed to a poor monsoon and
low agricultural output. Although this shows the dependence of the Indian economy on
its agricultural sector, growth of 4.4% despite a poor monsoon also demonstrates that the
economy is diversifying into other sectors. Today India has one of the six fastest
growing economies in the world. In the second quarter of 2003, GDP growth was 8.4%.
Growth for the fiscal year 2002/2003 is estimated at 8.2%. (See figure 5)
India achieved its first current account surplus in 24 years in the fiscal year
2002/2003. Major growth in the services sector, including information technology
outsourcing, as well as inflows from the Indian Diaspora contributed to the surplus. In
2002/2003, the current account surplus totaled USD$4.1 billion, while the trade deficit
was USD$7.7 billion. India’s principal goods exports are cotton, yarn, textile, readymade
garments, leather goods, gems, jewelry, and agricultural and processed food products.
Exports of merchandise grew by more than 20% in 2002, and the foreign reserves
increased to USD$109.6B. Increased productivity and exports from the IT services
industry moves the balance of payments (BB) curve outward. In addition, capital inflows
from Indians abroad increase the surplus and move the economy’s position on the BBNN
Economic reforms, if suited to growth, will contribute to outward movement in
the BB curve, increasing the value of the current account. Reforms began in earnest in
1991 following India’s payments crisis, in which the country had to borrow money from
the International Monetary Fund (IMF) to escape defaulting on payments. Before
providing funding, one of the conditions the IMF imposed on India was increased
liberalization of its economy. One of the most significant reforms was privatization of
State Owned Enterprises (SOEs.) Privatization has already had a profound effect on the
economy, despite moving slower than many proponents had hoped for. Privatization
initially targeted the power, steel, oil refining and exploration, road construction, air
transport, telecom, ports, mining, pharmaceuticals, and financial sectors. Also,
restrictions limiting the size of companies in the garments and textiles industry were
removed. Federal Direct Investment (FDI,) critical for promoting competition and
efficient industry, was welcomed in most sectors. Competition was also fomented by
reducing licensing and other governmental controls, although labor relations and
bankruptcy are still largely managed by the government. Many tariffs were lowered, and
most import quotas were eliminated. In addition, reforms have increased the efficiency
and attractiveness of India’s capital markets, which has attracted investments from
foreign institutional investors.
Exchange rate policy affects an economy’s position on the BBNN by determining
the competitiveness of its industry. With an artificially low exchange rate, exports will
be expensive and there will be pressure on wages to decrease. The opposite is true for an
artificially high exchange rate. In 1991, the rupee was devalued by 22% to better reflect
the real exchange rate, and a market exchange rate was introduced in 1993. Although
exchange rate policies have become much more flexible, capital outflows are still
regulated because of insecurities resulting from a weak banking sector, relatively high
fiscal deficit, the East Asian financial crisis, and conflict with Pakistan. The rupee has
been appreciating with respect to the dollar recently, in part because of India’s growing
foreign exchange reserves and continued economic liberalization.
Lastly, social indicators have improved since the economy opened up and
economic reforms began in 1991. The biggest gains have been in the south and along the
west coast, areas which have attracted industry and high tech. Literacy and life
expectancy have increased significantly. All of these factors contribute to a movement
upward in the social peace curve. (See figure 1)
The Indian ISLM
The ISLM model is comprised of two curves, the IS curve and the LM curve. The
IS curve (I stands for Investment and S stands for Savings) describes the market for real
goods and services, and the LM curve (L stands for Liquidity and M stands for Money)
describes the supply of and demand for money in an economy. A movement in either
curve has an affect on both interest rates and the production of goods and services. A
country’s fiscal policy is responsible for movements in the IS curve, whereas its
monetary policy is responsible for movements in the LM curve. The ISLM is useful for
explaining the effects that fiscal and monetary policies have on interest rates, inflation,
and short-term output. (India’s ISLM is illustrated in figure 4 of the appendix.)
For many years, India practiced expansionary fiscal policy, as witnessed by its
large fiscal deficit. The national deficit reached a high of 6.6% of GDP in 1991, when
the country suffered the payments crisis. Despite having recovered from the payments
crisis, India still maintains a large deficit. In 2002/2003 the national deficit was 5.9% of
GDP, and state deficits were an additional 4.2% of GDP. National and state deficits are
the result of excessive government spending, financed by borrowing from the public.
Expansionary fiscal policy pushes the IS curve out, raising interest rates and limiting the
amount of capital that is invested in the private sector. Today, India appears to be
adopting more conservative attitudes towards fiscal expenditures. Healthy economic
growth, stricter tax collection, and loan repayments by state governments should help to
reduce the deficit. (See figure 2)
India’s current government has been following an expansionary monetary policy.
In 2002, interest rates reached their lowest since 1974. Interest rates were able to decline
due to a period of low inflation. However, in the near future the central bank of India
may follow a contractionary monetary policy. It may raise interest rates in the coming
year to prevent inflation from rising. In a situation with stable fiscal policy, raising
interest rates is equivalent to restricting the money supply, or moving the LM inwards.
(See figures 3 and 4)
Aside from monetary policy, inflation in India is affected mainly by agricultural
support prices and GDP growth. Other major forces acting on inflation are increased
competition in the manufacturing sector, which has reduced inflation, and an increase in
the prices of fuels and raw materials, which increased inflation. Inflation was 10% from
1992 to 1997 but only 4.9% in 2001/2002, and is expected to remain around 5% for the
near future. (See figure 6)
India as a Transition Economy
Transition economies, in order to succeed, need political stability, an export base,
a coordinating device, property rights, and checks and balances such as a free press,
elections, accountability, and multi-party political systems.
India has a transition economy in that it is changing from a closed, socialist state
to a more open and liberalized system. In the 50s, 60s, and 70s, the country championed
import substitution and discouraged foreign direct investment. Since the 80s and
especially after the payments crisis in 1991, India has been moving towards a more open
economy and has been privatizing many government owned corporations. India has
political stability, due to its plethora of political parties and long-standing democratic
institutions. The judiciary, the election commission, and the media are strong institutions
in India that provide checks and balances. Finally, the payments crisis in 1991 acted as a
coordinating device, and has aligned the country’s multiply political parties around free
market reforms and economic liberalization.
Three Key Issues: Privatization, Agricultural Productivity, and IT Outsourcing
Privatization, agricultural productivity, and the information technology export
sector will be important catalysts for future economic growth. Privatization is paramount
to increasing productivity and competitiveness, as well as attracting foreign direct
investment. Agricultural productivity is necessary to free up labor for more enriching
economic activities, and for India to reach developed nation status. The information
technology export sector has already fueled much of India’s growth, and will grow in its
importance as the rupee appreciates against the dollar and wages begin to rise.
On Saturday, March 20, 2004, I was part of a group of students from Sloan that
met in Delhi with Dr. Arun Shourie, India’s Minister for IT, Communications, and
Disinvestment. A major part of our discussion involved disinvestment, or privatization.
The Indian government, according to Dr. Shourie, will not privatize companies in the
atomic energy, defense, and railway sectors, or the largest companies dedicated to
petroleum exploration and natural gas. The government decides which firms to privatize
based on the recommendations of the disinvestment commission, which assesses each of
the 1000 publicly owned corporations. Dr. Shourie seemed somewhat frustrated with the
speed with which the government was instituting reforms, and alluded to the fragmented
interest groups and political factions as a cause of the lethargic pace of progress.
The public sector is extremely inefficient when compared to the private sector,
and its large size makes it an obstacle to growth. In India, the state employs 70% of the
28 million workers in organized employment. In addition, the private sector would
benefit greatly from further liberalization and less government control. However, as
corroborated by the opinion of Dr. Shourie, many reforms have been delayed or cancelled
due to vested interest by many in the status quo. In particular, labor unions are powerful
and have strongly opposed labor reforms. (See figure 7)
Agricultural Productivity
Roughly two thirds of the workforce in India is employed in the agricultural
sector, and the majority of these workers are subsistence farmers. Despite its prominence
in total number of employees, agriculture accounts for only 25% of GDP. Productivity is
extremely low and the vast majority of farmers depend on the monsoon for a healthy
crop. Only 1/3rd of all cropland is irrigated, and few farmers have consistent access to
fertilizers, irrigation, or high-quality seeds.
One fourth of public investment is in agriculture, and this number will increase if
a new large scale government project to link many of India’s rivers is implemented.
Government initiatives to increase productivity, such as the Green Revolution, have
proved effective mostly for the wealthier farmers, who comprise 10% of farm households
but own 53% of farmland. The Green Revolution involved the dissemination of highyield crop varieties and advanced fertilization and irrigation techniques.
Government involvement in the agricultural sector has also prevented increases in
farm productivity. The government sets minimum support prices for food grains and
enforces these prices by purchasing part of the crop yield. This has caused the
governments food stores to exceed its storage capacity and has raised the prices of food
grains to artificially high levels. High support prices give farmers little incentive to
efficiently allocate their crop production according to market demand, or to produce a
larger variety of crops. Since domestic demand is artificially high for certain crops such
as sugar, cotton, just, vegetable oil, tea, and coffee,) farmers have neglected potentially
lucrative export markets in other crops such as rice, cotton, fruit, and flowers.
Information Technology Outsourcing
India has emerged as a leader in information technology services and advanced
research and development. Although this is surprising for a developing country, India’s
strengths in IT services are a natural outgrowth of the country’s competitive advantages.
India’s institutions of higher education produce the world’s second largest pool of
scientists and engineers (behind the US.) Additionally, these professionals are relatively
inexpensive to hire, costing ½ to ¼ that of an American software engineer. Due to its
previous status as an English colony, English is widely spoken, especially among the
educated classes.
The Indian software industry started to develop after IBM left India in 1977
because of policy differences with the government. Tata Consulting and other local
companies sought to fill the void by providing low end export services to multinationals.
These low end services comprised activities such as maintenance of legacy systems,
programming and testing for the Y2K millennium bug, and Euro conversion. Indians
educated in the United States facilitated the development of India’s IT sector, as many
moved back to India and accelerated the learning curve of local software companies.
Other Indians who stayed in the United States were able to strengthen relationships
between new Indian software firms and American multinationals. Also, declining prices
for data communications infrastructure and computer hardware, combined with lower
import tariffs in the 1990s, lowered the barriers to entry for new companies and increased
the range of services available for outsourcing. Many Indian companies that began with
low end services now specialize in more sophisticated IT services such as business
process outsourcing, primary research and development, and engineering design. Global
companies such as Lucent, Hewlett-Packard, IBM, Microsoft, Cisco, and Eli Lilly are
also establishing operations in India. GE’s largest R&D lab, which employs 2600
scientists, is in India in the city of Bangalore. As a testament to India’s sharp learning
curve in IT services, the country is home to over half of all software companies to have
achieved Carnegie Mellon University’s prestigious CMM Level-5 rating.
The IT sector’s growth has been equally impressive as its learning curve. By
2000, over 200 of the fortune 1000 companies were outsourcing software development to
India. In the same year, IT outsourcing had grown to 20% of India’s export revenues,
and services exports were larger than the combined exports from the country’s two
largest manufactured goods industries (textiles/garments and gems/jewelry.) IT services
had grown an average of 46% per year since 1993 and has remained an export industry:
foreign demand accounts for 80% of total production. The United States alone receives
60% of India’s software exports. By 2008, the services industry in India is predicted to
reach $87 billion, including $50 billion in exports. Also in 2008, Indian services
companies are predicted to number 400 and command a market capitalization of US$225
billion. These predictions would place India’s share of the US software market in 2008 at
a modest 4.1%.
Although India’s dual BBNNs may appear similar to China’s BBNNs, there is
one important difference. Growth in China’s private sector BBNN is related to the
increase in manufacturing in China, which creates a lot of jobs. Growth in India’s private
sector BBNN can be attributed largely to the successes of information technology
outsourcing. Dr. Shourie pointed out that India’s IT industry, as well as other promising
Indian industries such as pharmaceuticals, biotechnology, and nanotechnology, generate
publicity and income but do not create large numbers of jobs. This has a few
implications for future growth. Eventually, China will have to transition from a
manufacturing economy to more sophisticated industries. India will already have
competencies in high tech and will only need to grow these sectors as it develops.
However, early development of high tech may cause problems of income distribution.
Dr. Ravi Ramamurti, in his speech at Sloan on the 23rd of February, 2004, predicted that
the growth of the IT sector in India would widen the income gap between the rich and the
poor. Large income differentials often affect social peace, and may cause civil unrest. In
addition to promoting high tech industries, India will have to develop industries with the
potential for large scale job creation in order to eradicate poverty and maintain social
A Prescription for Future Growth
As reflected by its GDP growth, India has been following sound economic
policies since 1991. These policies should continue, although some could be refined or
enhanced, and new policies should be undertaken to insure continued economic growth in
the future. Specifically, India should institute faster privatization (if possible,) including
privatizing industries that the government has excluded from disinvestment plans,
increase agricultural productivity and ease the transition of subsistence farmers into the
national economy, and continue infrastructure development and promotion of IT and
other high tech sectors.
Privatization and increased agricultural productivity will have an immediate effect
of increasing the labor pool, which will increase the level of unemployment. However,
as long as the economy is growing, new jobs will soon be available to displaced public
sector employees and farmers. These new jobs will be better and more productive than
the public sector positions previously available. Employment will flow to where it will
be most efficiently used, thus feeding a virtuous cycle of job creation and raising the
government’s tax base. Also, selling public corporations will increase government
revenues and help to reduce the fiscal deficit, as long as fiscal expenditures are relatively
A flood of new workers into the workforce will put pressure on wages to
decrease, if all other factors are held constant. This may be good for the Indian economy
because the rupee has been appreciating, making the economy as a whole less
competitive. An appreciating currency is not good for a transition economy since there is
latent unemployment due to excess employment in the underperforming public sector.
Job creation is easier when exports are more competitively priced. Although the speed of
privatization should increase, it should not happen all at once. Sudden massive
unemployment would not be palatable for many citizens and could create social unrest.
A portion of the additional income generated through privatization should be
spent on infrastructure projects and other programs aimed at increasing agricultural
productivity. Increased agricultural productivity can be achieved through education,
increased use of technology, better infrastructure, and less government involvement in
produce markets.
Government participation in agricultural markets should be limited to promoting
renewable energy and reducing both pollution and India’s dependence on foreign oil. Dr.
Shourie advocated government subsidies for growing oil rich seeds that can be used to
produce energy. Support prices should be gradually eliminated, which will have the
added benefit of allowing farmers to produce agricultural goods for profitable export
markets. In addition, specialization and larger farm sizes will facilitate an increase in
As infrastructure improves, new economic activities will be possible, trade will
increase, and companies will become more efficient. An increase in agricultural
productivity will cause the relocation of many subsistence and small scale farmers to
other industries in rural and urban settings. New job creation due to improved
infrastructure will become available to the displaced farmers, who would eventually
achieve a better standard of living and contribute more to the growth of the Indian
economy. (See figure 8)
India has benefited greatly from its promotion of the IT sector. Business process
outsourcing, engineering design, call centers, and other similar industries are well suited
to take advantage of India’s robust telecommunications and data processing networks.
Bangalore and Hyderabad, both cities in southern India, have experienced tremendous
successes with the growth of software and other skill intensive industries. The
government’s role in this growth has been positive, by easing regulations and by
investing in advanced telecommunications infrastructure. This infrastructure, while
much less costly, has achieved similar economic goals as building more traditional
infrastructure such as railways and ports. Promotion of IT and other high tech sectors
should continue and included areas such as pharmaceuticals, biotechnology, and
nanotechnology. If India is to sustain growth, its services sector should look to build
competitive advantages that are not dependent on cost arbitrage, as this may disappear in
the future. India should focus on leveraging skills and talent and producing cutting edge
technology to prepare itself for future competition as a first world economic power.
These policies, if successful, would further alter India’s economic landscape and
produce changes that can be easily illustrated by the BBNN. As productivity increases in
the agricultural sector, migration to the cities will increase, further pushing the NN
outward and raising the level of unemployment. Non agricultural economic activity must
continue to grow to absorb these workers. Increased productivity in agriculture may also
provide an economic stimulus to small towns by allowing subsistence farmers to
concentrate on other activities.
The rupee would maintain its position relative to the dollar, despite impressive
and sustained growth in IT and other high tech sectors. Growth in these industries would
be helped by the stable exchange rate. A stable rupee would also give high tech
companies time to develop strong competitive advantages in preparation for the future
appreciation of the rupee and a less forgiving competitive landscape.
In the small towns, migration to the cities and productivity increases in agriculture
will result in the small town BBNN depicted below. Population decreases, output
increases slightly, and incomes increase significantly. (See figure 9)
Even if these policies are successful, it may take 20 to 30 years before the real
natural rate of unemployment is reached and the rupee begins to appreciate. The
numbers of workers who must transition from public companies and agriculture to
industry in the private sector is overwhelming. Two thirds of the work force is employed
in agriculture, and 70% of the remaining workers (in organized employment) are
employed by the government. If these numbers are correct, 80% percent of the organized
workforce would need to transition to private sector industry (given that 10% of the
workforce remains in agriculture.) The biggest risk from increased productivity in the
agricultural sector is that job creation in industry and in the cities will not keep up with
the increasing supply of labor. Another risk is that total agricultural production will
decline. Agricultural productivity will need to rise at least as quickly as the transition
from agriculture to industry takes place. For example, if productivity rises 4% per year,
4% of the agricultural workforce can find jobs outside of farming every year, while
maintaining prices and output stable. In actuality, productivity may rise faster than the
industry transition, since rising incomes will most likely increase demand for agricultural
India has seen impressive rates of growth in the last 13 years. If it continues its
policies of economic liberalization and privatization, it may eradicate extreme poverty
among its people within the next twenty or thirty years. India is poised to contribute
significantly to advances in science and technology, and its development will benefit not
just India, but the entire world.
Appendix: Graphs and Charts
Figure 1
Figure 2
Source: Confederation of Indian Industry
Rate (%)
Figure 3
Central Bank Discount Rate
Source: Global Financial Data Inc.
Figure 4
Figure 5
Real GDP Grow th Rate
Source: Confederation of Indian Industry
Figure 6
CPI Inflation Rate
Source: Global Financial Data Inc.
Figure 7
Figure 8
Figure 9
- The Economist Intelligence Unit. April 2004. Country Report – India.
- The Economist Intelligence Unit. April 2004. Country Profile – India.
- The Economist Intelligence Unit. April 2004. Country Commerce – India.
- Report for Congress - Received through the CRS Web, Developing Countries:
Definitions, Concepts and Comparisons, December 6, 2002
- Jonathan E. Sanford, Specialist in International, Political, Economy, Foreign Affairs,
Defense, and Trade Division
- Anjula Sandhu, Research Associate, Foreign Affairs, Defense and Trade Division
- Congressional Research Service ˜ The Library of Congress
- Devesh Kapur and Ravi Ramamurti, “India’s Emerging Competitive Advantage in
- Meeting with Dr. Arun Shourie, New Delhi, India, March 20, 2004.
- Concepts from the textbook, Macroeconomics, 3rd Edition, Blanchard, 2002.
- Confederation of Indian Industry:
- India Brand Equity Foundation: