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Clouds on India's Economic Horizon

There are plenty of good reasons to be bullish on India. The country is at peace with its neighbors. Its democracy offers long-term political stability. Its central government continues to ease controls on foreign trade and investment. A wealth of managerial and entrepreneurial talent is driving what is now the world's second-fastest growing economy. But there are clouds on India's horizon, and the robust growth of recent years may not last.

Over the past decade, high-tech services and domestic consumption have helped India's GDP expand by about 7 percent per year, rising to 8.5 percent in both 2006 and 2007. The Organization for Economic Cooperation and Development forecasts that growth will slow this year -- but should still reach 7.8 percent. India now has a $1 trillion economy, and its middle class has grown to about 250 million people.

Most developing states outside of Latin America are currently contending with regional political instability. But now that historically hostile relations with neighboring Pakistan have stabilized and relations with China have improved, there are few urgent foreign-policy challenges to distract Indian policymakers from the process of economic liberalization. Throw in the number of younger Indians who speak English and the contributions of capital and know-how from the global Indian diaspora and it's not difficult to see why things are going so well.

India also benefits from the steady growth of its labor force. Within five years, China will begin to face a serious demographic problem, as the one-child policy throws population growth into reverse. In Russia, the population is already falling, as poor public health conditions take their toll on Russian workers. Half of all Indians haven't yet celebrated their 25th birthday, and the population continues to grow in harmony with the country's demand for labor.

It gets better. At a time of surging global demand for increasingly expensive energy resources, off-shore discoveries of substantial quantities of natural gas can help feed India's growing appetite for energy and limit its reliance on imports from Iran and the Gulf States.

The Indian firm Reliance Industries has helped India become a global leader in both refinery construction and deep-water exploration projects.

Yet, there are several emerging problems that may cool off India's economy over the next several years. First, its political party system is fragmenting, as a growing number of small regional and caste-based parties are becoming increasingly important for the country's political balance of power.

The vote share of the two largest parties -- the Congress Party and the Bharatiya Janata Party (BJP) -- has fallen steadily in recent years. Smaller parties are winning more and more votes, and their support has become ever more critical for the formation of a durable government. The greater the number of politically relevant parties, the greater the number of concessions that must be made as reform projects are formulated.

In addition, the opposition BJP is gaining strength at the expense of the ruling alliance. With the U.S.-India nuclear deal generating frictions between the Congress Party and some of its leftist allies -- and food inflation running at about 20 percent -- the BJP looks like an increasingly strong contender in upcoming elections (due by May 2009). Sweeping grassroots criticism of Congress Party leader Sonia Gandhi and the inability of the Congress-led government to satisfy its traditional constituencies -- the urban poor and rural workers -- aren't helping.

Whatever the elections outcome, the next coalition government will likely include more regional and caste-based parties. That means that a larger number of entrenched local interests will have to be accommodated if the government is to forge the political deals that further economic liberalization will require.

Further, nationwide infrastructure problems continue to drag on economic growth. India can't afford more of the political infighting that already slows efforts to meet surging demand for better roads, railways, bridges, ports, airports, communications networks and additional power-generation capacity. Private investment has made a difference in recent years, particularly in the telecommunications and civil aviation sectors, but political opposition to privatization in many areas leaves much of the spending burden on India's central government.

Finally, and crucially, much of India's current growth comes from advanced industrial sectors -- services, software and information technology. These are areas in which bureaucrats and local politicians aren't able to create roadblocks. This has cleared the way for talented government managers to build efficient regulatory environments more or less from scratch, free of the obstacles so often created by self-interested local bosses.

India's technology sector offers a prime example. To stimulate growth in a new sector, the Indian government found the most capable technical minds available, created the National Association of Software and Services Companies (Nasscom) -- an organization charged with maximizing efficiency -- and constructed an extremely attractive sector for foreign direct investment.

That's worked well for an Indian economy in which a tiny fraction of the population helped drive the boom. But as its government works to attract investment in sectors that will depend on a broader cross-section of the country's people -- in manufacturing, medium and heavy industry, and the automotive and retail sectors, for example -- it won't be easy to keep local politics from tying the reform process in knots. This is the Indian economy's "dirty little secret," and the country's industrialists understand this all too well. Many of them continue to look outside the country to help their companies grow.

China doesn't have this problem. Until its labor pool shrinks, environmental degradation reaches a crisis point or social instability becomes systemic, Beijing can rely on central planning to resolve the structural problems that limit its economic growth. In India, on the other hand, the vagaries of coalition politics will weigh on efforts to develop a broader manufacturing base -- a transition India must make if its wealth and productivity are to be distributed more evenly and robust growth is to continue.

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