For India and Indonesia, Quality Growth Requires Quality Governance

By David A. Parker

Kid in Bombay

Boy crosses a flooded street in Dharavi Slum, Bombay. Emerging economies India and Indonesia face challenges in their efforts to ensure economic growth for their people. Source: Thomas Leuthard’s flickr photostream, used under a creative commons license.

Fortune has been fickle for emerging markets of late. Weeks after larger-than-expected current account deficits and the prospect of tighter monetary policy in the United States brought the value of the Indian rupee and Indonesian rupiah tumbling downward, surprise news on September 18 that the Federal Reserve will be maintaining its dovish stance prompted both countries’ currencies and stock markets to shift upward.

Despite being welcome news for New Delhi and Jakarta, policymakers in both capitals should be careful not to read in this slight reprieve signs that all will soon be well. In order to address their structural imbalances and enable the quality growth needed to provide jobs for large, youthful populations, India and Indonesia will need to work hard to address the poor governance – at all levels – that is at the heart of their current economic challenges.

Popular policy misadventures have certainly also played a role in making both countries vulnerable to the recent shifts in market sentiment. India’s wide array of pro-poor policies, which includes generous subsidies for fuel and food, has helped boost the government’s fiscal deficit to a whopping 9 percent of gross domestic product. Even with Jakarta’s recent move to raise fuel prices by nearly 50 percent, subsidies this year will still cost the central government over $21 billion – more than its combined budget for healthcare, education, and public works.

Yet managing consequences of these policies is only the most obvious challenge policymakers now face. More difficult will be remedying the structural issues that have become increasingly deep-rooted over the past decade.

Chief among these is the persistent decline of manufacturing. Export-competitive manufacturing is critical to development, supplying jobs for low-skilled labor in its early stages and often serving as a crucial source of foreign exchange, in addition to providing a host of other positive spillovers. As value chains have extended throughout the region and multinationals have looked to diversify their production bases outside of China, India and Indonesia would seem well-placed to attract labor-intensive manufacturing investment. Both countries boast low wages and young, rapidly growing workforces that are already the world’s second- and fifth-largest, respectively.

But recent economic history in both countries tells a strikingly different story. In India, service sector industries, such as call centers and software writing, have been the primary driver of growth. They now account for nearly two-thirds of national output, compared with only 14 percent for manufacturing. In Indonesia, much of the economy’s recent expansion has come on the back of booming commodity exports. While manufacturing still represents nearly a quarter of overall economic activity, the sector has grown increasingly uncompetitive and faces erosion from low cost competitors like Vietnam and Bangladesh.

Much of this poor performance is due to the nature of manufacturing, where the quality and reliability of hard and soft infrastructure have an unusually large impact on competitiveness. India and Indonesia are notorious for their difficult business climates, which share the devastating combination of insufficient (or nonexistent) roads and railways, and unreliable access to electricity, mixed with cumbersome bureaucracy, constantly shifting regulations, and endless uncertainty over land rights, taxation, and fees.

Fixing this will require improving the quality and consistency of economic governance at the regional and local levels. Reforms have empowered subnational governments in both countries, meaning that while New Delhi and Jakarta remain fond of setting billion, and even trillion, dollar investment targets, actual improvements in their respective business climates will hinge on the ability (and willingness) of lower-level officials to turn targets into realities.

For every star performer taking two steps forward, such as India’s Gujarat state or Indonesia’s Yogyakarta region, it seems corruption, populist policies, or simple incompetence among the laggards drag the overall quality of governance one step back, with negative consequences for all. India’s labyrinthine internal customs regime is one example, where states’ competition for revenue and control over border regulations has led to a multiplying of cumbersome fees, checks, and regulations that have dramatically increased the cost of transporting goods throughout the country.

Despite these challenges, it would be a mistake to underestimate the economic potential of the world’s first- and third-largest democracies. Policymaking in New Delhi and Jakarta will likely settle after national election cycles finish in 2014. Both countries’ low income levels, expanding workforces, and strong domestic consumer bases mean their medium term growth rates will almost certainly outpace those of advanced economies. But whether India and Indonesia will average economic growth in the 4-5 percent range or the 7-8 percent range will depend heavily on the quality of economic governance at all levels.

The difference matters. The Indian and Indonesian economies will together need to supply nearly 200 million additional jobs to keep up with expected growth in the workforce between now and 2030. If they succeed, they will rank among the world’s greatest development success stories. And with the economic future of nearly 1.4 billion people at stake, failure is not an option.

Mr. David A. Parker is a Research Associate with the Simon Chair in Political Economy at CSIS.

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