India lost the manufacturing race to China. Here's why it could still succeed

Today is India’s election day. Well, technically, it’s the day that the official results from India's election are expected to be announced. Voting has been going on for the past six weeks. It apparently takes a long time for 900 million voters to cast their ballots.

The economy is a top concern for Indian voters. And, if they were to compare their economy’s long-run trajectory to their neighbor to the northeast — China — they might have a lot to complain about.

Back in 1980, India and China were roughly equal when it came to earning money. Both nations’ GDP per capita — or, more casually speaking, their average income per resident — was around $300 per year.

In the decades since 1980, however, the fortunes of the Chinese have rocketed dramatically ahead of the Indians. The average Chinese resident now makes over $13,000 per year. The average Indian resident makes only about $2,700. China’s economy, in other words, has grown almost five times faster than India’s.

The core reason for China’s economic success: manufacturing. China now produces around 35 percent of the world’s manufactured goods. Manufacturing has also been central to the economic success of virtually every other nation that has gone from rags to riches.

India has lagged far behind in manufacturing. Despite representing almost 18 percent of the entire world’s population, India produces only around 2 to 3 percent of the world’s manufactured goods. That number has barely budged since the 1980s.

So it makes sense that Prime Minister Narendra Modi, who is widely expected to be elected to a third term today, has made manufacturing a centerpiece of his development strategy for India. The Modi administration has been protecting and subsidizing strategic manufacturing sectors, like textiles and electronics, to the tune of billions of dollars per year.

This is all wrong, argues Raghuram Rajan. And he’s not just some random dude. Rajan is the former head of the Central Bank of India, the former chief economist of the International Monetary Fund, and now a professor at the University of Chicago Booth School of Business. Together with Rohit Lamba, he has a new book out titled Breaking the Mold: India's Untraveled Path to Prosperity.

We at Planet Money recently spoke with Rajan about India's challenges and opportunities to become rich, why the manufacturing-led road that China paved may not be open to India, and the route that Rajan believes India should take instead.

The Ticking Clock For Indian Economic Development

While India’s economy has fallen dramatically behind China’s in recent decades, it’s been looking better recently. India’s GDP is projected to grow over 6.5% this year. That’s more than double the United States and many other rich countries. Companies like Apple have been shifting production to India. Under the Modi government, the country has seen an explosion of investment in infrastructure, like roads, railways, and ports. The stock market is booming. And it looks like India is steadily marching to soon become the third largest economy in the world.

However, Rajan expresses a lot of concern about India’s economy. Sure, he says, it may be growing fast compared to many rich countries. But, he says, it needs to grow much, much faster to have any chance of eradicating the extreme poverty and joblessness that plagues the world’s most populous country (over 1.4 billion people!)

When Rajan looks at the Indian economy, he sees a ticking clock. India, he says, is currently experiencing what social scientists call “the demographic dividend.” It has a lot of young people entering the workforce and relatively few old people. This Goldilocks period for growth, Rajan predicts, will only last about 25 years in India. After that, the country’s population will skew older, fewer people will work, and more people will require government assistance to meet their needs. The economy will predictably slow down (as seems to be the case with an aging China recently).

“So the question is: what level of growth does India need over the next 25 years to become rich before it becomes old?” Rajan says. “And the answer is much higher than 6.5 percent. If you look at China in the early 2000s, it was growing at 10, 12, 14 percent.”

Rajan argues that India is squandering the gleaming opportunity of its demographic dividend. Despite having this huge economic advantage of an abundance of young people, “these young kids coming into the labor force are not finding jobs,” Rajan says. Lacking good job opportunities, some of the brightest graduates of India’s elite engineering schools tend to migrate abroad. The current government’s strategy of trying to retrace China and many other countries’ manufacturing-led path to greater riches, Rajan argues, is not working.

The big reason why: manufacturing has become much more competitive. When earlier developers, like China, entered the marketplace, they were competing against “costly Western labor,” Rajan says. That gave them a big competitive advantage: cheap labor.

“Today, when India enters, it's not competing with Western countries, it is competing with Bangladesh, Vietnam, and still China,” Rajan says. That means India has much less room to make globs of money in manufacturing.

If not manufacturing, then what?

While India’s manufacturing sector has limped along, it’s doing increasingly well in services. For those of us who have dealt with customer service or IT departments of major American corporations, you’re probably familiar with dealing with someone based in India on the telephone. However, India specializes in higher skilled services as well. Rajan says companies like Boeing, Victoria’s Secret, Goldman Sachs, and JP Morgan have been increasingly turning to Indians to do high-skill services. “JP Morgan, for example, has 3,000 lawyers in India, making contracts for the rest of JP Morgan's functions across the world,” Rajan says.

Even when it comes to physical products, like the iPhone, the money tends to be services, like design and marketing. “Apple hasn’t manufactured anything since 2004,” Rajan says. It outsources its manufacturing to the company Foxconn. Apple is worth nearly $3 trillion. Foxconn is worth only about $80 billion.

With the explosion of remote work since the pandemic, Rajan believes the outsourcing of services to India can be supercharged. To borrow from his book's title, Rajan now believes India can break from the cookie-cutter mold of manufacturing-led development and leapfrog into service sectors that have tended to be dominated by the workers of rich countries. He imagines Indians providing many more services to Westerners and others around the world, in areas such as telemedicine, design, consulting, even Yoga instruction.

To achieve this vision, Rajan believes India needs to shift strategies “from brawn to brain.” Right now, the country is pursuing industrial policies like pouring billions of taxpayer subsidies into manufacturing. But, Rajan argues, they should be more flexible and open-minded about the country’s development path.

The money currently being poured into building up manufacturing, Rajan argues, would be better spent on improving poorly funded public schools, building world-class universities, and training workers to thrive in the growing services sector. Indian leaders should also, he says, create a more business-friendly regulatory environment and invest in social programs like childcare, which would allow more Indians to enter the workforce.

India may have “missed the manufacturing bus,” but, Rajan says, it can still grow rich by jumping on the services train. Sure, we haven’t really seen any poor country leapfrog like this before. But Rajan believes India is well-suited to do it. It’s got a massive population of English speakers. The Internet has enabled more services to be done remotely. And Indian service providers are willing to work for much less than their Western counterparts.

And India is still a democracy. Sure, Rajan says, there’s a strong case to be made that China’s undemocratic authoritarianism may have actually helped it squash opposition and strong-arm its way to becoming a manufacturing powerhouse. But, he argues, democracy is an asset for India going forward because, he argues, democracy keeps leaders accountable and political freedom empowers citizens to buck orthodoxies, challenge the establishment, and be more creative and innovative. He is concerned that, under Prime Minister Modi, India has taken a more authoritarian turn.

In a future Planet Money newsletter, we will dive deeper into the question of whether democracy is an asset or a liability for economic growth. Stay tuned.