For much of the first decade of the twenty-first century, India’s economy captivated the world’s imagination. Other countries looked on enviously as India became the fastest-growing free-market democracy, seemingly vaulting effortlessly from the status of a nation mired in poverty into that of a high-tech, car-owning, middle-class society. Powered by information technology companies such as Infosys, Tata Consultancy Services, and Wipro, the country was poised to be a global player, perhaps even an economic superpower.

But then came the global financial crisis of 2008. India’s three­-decade-long structural transformation ground to a halt and remained at a standstill for more than a decade, as the initial shock was compounded by years of poor economic management. By the time the COVID-19 pandemic struck, the world had turned its attention away, with India seemingly disappearing from the global economic map.

In 2021, however, India suddenly reappeared. Foreign portfolio managers, convinced that the country was on the move again, funneled money into its stock market, sending it soaring. Venture capitalists poured money into “digitech” (digital technology) startups, seizing on India’s unique combination of computer engineering talent, dynamic entrepreneurs, and market potential. Indeed, a new “unicorn”—a startup valued at more than $1 billion—seems to appear every month, in cloud computing, education, entertainment, finance, payments, tourism. Altogether, there are now nearly 70 such unicorns in India, more than in any other country except China and the United States.

Meanwhile, international manufacturing firms have also started to look toward India, as they seek to diversify their production away from China. After all, with its huge domestic market, sizable pool of skilled, English-speaking managers, and vast reservoir of young, low-skilled workers, India seems well suited to produce labor-intensive export goods. All this has left many asking: Is India back?

The question is far more difficult to answer than some of the recent economic data suggest. Without a doubt, India has made impressive recent progress in building the “hardware” of economic success—its physical and digital infrastructure, its ability to provide tangible basic goods to its population, and its strong base of skilled engineers and entrepreneurs. Yet at the same time, the country continues to struggle to fix its “software,” the crucial economic framework under which domestic entrepreneurs and foreign firms must operate. Policies are changed abruptly; rules are altered to favor certain firms. As a result, domestic entrepreneurs and foreign companies have been reluctant to undertake the investments needed to exploit India’s rapidly advancing hardware. Whether India manages to boom again and become a serious alternative to China will depend on whether the country can finally overcome the long-standing defects in its policy software. If not, the recent growth spurt is likely to prove another false start in a country of immense promise.

INDIA’S LOST DECADE

To answer the question of whether India is back, it is important to first understand when and why India went away. The answer lies in plans that went badly wrong. During the boom years after the turn of the millennium, Indian firms invested heavily, on the assumption of continued rapid growth. So when the financial crisis brought the boom to an end, causing interest rates to soar and exchange rates to collapse, many large companies found it difficult to repay their debts. As companies began to default, banks were saddled with nonperforming loans, exceeding ten percent of their assets.

In response, successive governments launched initiative after initiative to address this “twin balance sheet” problem, initially asking banks to postpone repayments, later encouraging banks and firms to resolve their problems through an improved bankruptcy system. These measures gradually alleviated the debt problem, but they still left many firms too financially feeble to invest and banks reluctant to lend. And with lackluster investment and exports, the economy was unable to recover its former dynamism.

As growth slowed, other indicators of social and economic progress deteriorated. Continuing a long-term decline, female participation in the labor force reached its lowest level since Indian independence in 1948. The country’s already small manufacturing sector shrank to just 13 percent of overall GDP. After decades of improvement, progress on child health goals, such as reducing stunting, diarrhea, and acute respiratory illnesses, stalled.

And then came COVID-19, bringing with it extraordinary economic and human devastation. As the pandemic spread in 2020, the economy withered, shrinking by more than seven percent, the worst performance among major developing countries. Reversing a long-term downward trend, poverty increased substantially. And although large enterprises weathered the shock, small and medium-sized businesses were ravaged, adding to difficulties they already faced following the government’s 2016 demonetization, when 86 percent of the currency was declared invalid overnight, and the 2017 introduction of a complex goods and services tax, or GST, a value-added tax that has hit smaller companies especially hard. Perhaps the most telling statistic, for an economy with an aspiring, upwardly mobile middle class, came from the automobile industry: the number of cars sold in 2020 was the same as in 2012.

In early 2021, the country’s population and health system were hit by a catastrophic second wave of the pandemic. Estimated at over 70 percent, India’s infection rate became one of the highest in the world, leading to an estimated 2.5 million to 4.5 million excess deaths. And many of those who survived found their lives blighted: heads of families faced immense medical bills, while their children were kept out of school for 18 months. In a country where learning outcomes are already modest, a generation of children have fallen further behind.

Adding to a decade of stagnation, the ravages of COVID-19 have had a severe effect on Indians’ economic outlook. In June 2021, the central bank’s consumer confidence index fell to a record low, with 75 percent of those surveyed saying they believed that economic conditions had deteriorated, the worst assessment in the history of the survey.

Disaffection is also manifest in politics. The national government in New Delhi has been bickering with the country’s state governments for more than a year over the sharing of revenue from the GST. Several states have imposed new residency requirements on job seekers over the past two years, thus directly challenging the principle of a common national labor market. There has also been a revival of the policy of “reservation,” India’s version of affirmative action, in which some jobs are reserved for people from traditionally disadvantaged social groups.

IMPROVING HARDWARE, FIXING SOFTWARE

Yet even as India’s structural transformation has slowed, the government has been busy building the foundations for a renewed boom, by strengthening the economy’s hardware and attempting to remedy some of the problems of its software. A number of the hardware improvements are readily visible. Rail and road networks have been expanded, with some major new highways and the Delhi–Mumbai freight corridor nearing completion, alleviating India’s most obvious constraint on growth. At the same time, important digital infrastructure has also been built. A national digital payments system, the Unified Payments Interface, or UPI, has been established, allowing digital companies to innovate and providing a newly efficient means for the government to deliver cash subsidies to the poor.

Less visible, but perhaps even more important—and probably the economic bedrock of Prime Minister Narendra Modi’s political success—has been the government’s distinctive approach to redistributive development. In many other countries, social spending has traditionally focused on intangible public goods, such as health and education. Since 2015, the Modi government has instead invested in programs that provide tangible basic goods and services, many of which are aimed at women. This “New Welfarism” has included bank accounts, cooking gas, toilets, electricity, housing, and, more recently, water and just plain cash.

Although some of the claims have been overstated, the achievements of the New Welfarism are real. By 2019, 98 percent of all households had access to electricity, up from just 75 percent a decade ago, and 60 percent had access to clean cooking gas. According to survey data, nearly three-quarters of all Indian women now have bank accounts that they can use themselves. And the government’s subsidies to the poor—previously known for extraordinary rates of “leakage”—are now provided in direct cash payments, ensuring that they reach their intended beneficiaries. They now amount to $100 billion per year.

At the same time, the government has taken major steps to improve the country’s policy software, especially its rules governing economic investment. Consider three of these initiatives. In 2019, the corporate tax rate was reduced to 25 percent from 35 percent, and new manufacturing firms were offered the possibility of securing a tax rate of just 15 percent. In August 2021, the government announced that it would settle nearly $7 billion in tax disputes, notably with the British firms Cairn Energy and Vodafone, arising from a poorly designed, decade-old law that taxed foreign companies retrospectively. And in October 2021, the government privatized India’s iconic national airline, Air India, selling it back to its original owner, the Tata Group (the multinational conglomerate that also owns Tata Consultancy Services), after 68 years of maladroit public ownership.

All these measures aim to grow the private sector—and to signal the government’s commitment to this objective. Indeed, further ambitious reforms are in the pipeline, including plans to monetize other public-sector assets, liberalize the farm economy, and clean up India’s arcane, archaic, and arbitrary labor laws.

Such market-friendly reforms might lead one to conclude that India’s software, just like its hardware, is rapidly improving. But this conclusion would be premature. Even as some aspects of the policy framework have been streamlined, new, much larger obstacles to private-sector growth have been put in place. To understand the problem, consider the centerpiece of the government’s current approach to growth, its industrial policy, which is intended to spur strategic industries and promote “national champions.”

ASPIRING OUTWARD, TURNING INWARD

The Modi government’s new industrial policy is motivated by its well-founded desire to lure international manufacturing away from an increasingly uncompetitive China. Since the financial crisis, China has given up about $150 billion of global market share in labor-intensive goods. Yet until now, India has been able to attract no more than ten percent of that lost share. In an effort to capture a far greater amount, the government has launched a three-pronged strategy, called Atmanirbhar Bharat (Self-Reliant India), that is based on targeted subsidies, a return to protectionism, and nonparticipation in regional trade agreements.

The subsidies take the form of production-linked incentives (PLIs) for manufacturers in designated sectors, including makers of cell phones, electronics, and pharmaceuticals. Available to both domestic and foreign-owned companies, the PLIs could cost the government about one percent of GDP over five years.

As a further spur to domestic production, especially in favored sectors, the government has reversed a three-decade-long consensus and begun raising import tariffs. Since 2014, there have been some 3,200 tariff increases, affecting about 70 percent of total imports. As a result, the average tariff rate has increased from 13 percent to nearly 18 percent, pushing India’s trade barriers well above those of its East Asian counterparts.

Finally, the Modi government has halted the efforts of its predecessors to join regional trade accords, concluding that it would be better to stay out of the China-centric Asian production system. Under Modi’s predecessor, Manmohan Singh, India signed 11 trade agreements; since Modi came to power, in 2014, it has signed none. Notably, the Modi government has declined to participate in the Regional Comprehensive Economic Partnership, a pact that has been joined by nearly all Asian countries, including China, Japan, South Korea, and the ten member states of the Association of Southeast Asian Nations, or ASEAN, as well as Australia and New Zealand. India’s trade negotiations with the European Union have also made little progress.

Will Self-Reliant India work? It is doubtful. After all, India has seen this movie before: the industrial strategy bears striking similarities to the country’s post-independence economic policy, which was abandoned in 1991, after India had fallen far behind its more market-oriented Asian competitors. The new approach, the “subsidy raj,” carries all the risks of the old “license raj,” namely that it is hard to enforce, is driven by arbitrary decision-making, and creates a system of entitlements from which it will be difficult to exit.

Nor does the strategy address the country’s most pressing needs. India’s population remains young, with large numbers of low-skilled workers looking for gainful employment in sectors that will provide them with a reasonable and growing wage. To satisfy their aspirations, India needs to follow the Asian recipe of boosting labor-intensive exports. But the PLIs are aimed instead at technology and capital ­intensive sectors, such as cell phones, which will provide relatively few jobs for the bulk of the population.

More to the point, the protectionist tariff regime is unlikely to lure manufacturers away from China. Higher tariffs will make it difficult for firms to access the inexpensive, high-quality imported inputs on which modern production depends. And India’s decision to stay out of Asia’s most comprehensive trade agreement means that the country’s exports will face a disadvantage in many of the world’s most dynamic markets. In other words, at precisely the moment when India has its long-awaited chance to compete with China for the first time as a global manufacturing center, the government is making it harder to integrate the Indian economy into global supply chains.

STACKING THE DECK

Perhaps the most distinctive aspect of Modi’s industrial policy is its promotion of companies that have acquired a dominant position in particular sectors of the economy. Japan and South Korea adopted a similar “national champions” strategy decades ago, with their zaibatsu and chaebol conglomerates. Consequently, the arguments for it are well known. With government assistance, favored companies can achieve huge economies of scale, create networks, and help pursue national economic goals. They can also strengthen a country’s position in the global market.

In India, the strategy has centered on two large business conglomerates, the Adani Group and Reliance Industries, led by two of the richest men in Asia, Gautam Adani and Mukesh Ambani. One positive outcome of this strategy has been the rollout of a low-cost 4G cell phone network by Jio, a Reliance subsidiary, which has given hundreds of millions of Indians access to the Internet for the first time. Another could be that these two giant companies could help India meet its climate goals, since they are both making large investments in renewables.

But such beneficial developments have to be weighed against the negative effects. For every favored firm that has been encouraged to expand, many other firms have been discouraged, by rules that make it difficult for them to compete with the national champions. Even as Reliance Jio was expanding rapidly, the telecommunications firms Bharti Airtel and Vodafone were being crippled financially, rendering them unable to invest the huge sums needed to shift India’s cell phone system rapidly to 5G. Similarly, the plans of Amazon, the Tata Group, and Walmart to develop their online retail platforms in India have been dashed by a proposed change in regulations. Domestic garment exporters have been handicapped by the high input cost of manmade fibers, favoring Reliance, which produces these fibers. Overall, then, the strategy has undermined the objective of improving the investment climate.

The cumulative impact of the national champions approach could be more serious in India than elsewhere because Adani’s and Ambani’s conglomerates have interests that extend throughout the economy, in defense production, ports and airports, energy, natural gas, petroleum and petrochemicals, digital platforms, telecommunications, entertainment, media, retail, textiles, financial payments, and education. By backing the “2As” at the expense of other companies, both domestic and foreign, the government is encouraging an extraordinary concentration of economic power.

In Japan and South Korea, the economic power of the zaibatsu and the chaebol was kept in check because they generally operated in tradable sectors where they had to demonstrate efficiency by competing globally. But the 2As operate mostly in domestic infrastructure sectors that are shielded from international competition and heavily shaped by government regulation. As a result, there is a serious risk that India’s national champions strategy could create an oligopolistic economy that will stifle innovation and growth.

STIGMATIZED CAPITALISM

Perhaps most worrisome, the national champions strategy threatens to intensify India’s historic problem of “stigmatized capitalism.” Many Indians are deeply ambivalent about the private sector—and capitalism generally. India’s private sector still bears the stigma of having been midwifed under the license raj, an era in which corruption was pervasive. To this day, some of India’s biggest entrepreneurs are believed to have built their empires simply by mastering the minutiae of India’s tariff and tax codes and then manipulating them brazenly to their advantage.

Some of the taint surrounding the private sector was cleansed by the 1990s boom in information technology, which developed by virtue of its distance from, rather than proximity to, the government. But then came the infrastructure boom during the years before the financial crisis, in which public resources—land, coal, the telecommunications spectrum—were captured by private firms under the previous government’s “rent raj.” And the current government has chosen to favor two groups through regulatory favors and privileged access to infrastructure contracts. This is stigmatized capitalism, the 2A variant.

Such favoritism seems unlikely to build public support for market-based reforms. In fact, it already has turned many Indians against them. Last year, the government decided to liberalize the highly regimented farming sector, a measure that the entire policy establishment had long been urging it to take. But unexpectedly, some of the intended beneficiaries decided to oppose the measure, partly because they feared that the new system would prove to be an oligopoly dominated by the 2As, which would force down farm prices. The government tried to convince the farmers otherwise but did not succeed. In late November, after more than a year of protests, the government announced it would withdraw the law.

DEFECTIVE SOFTWARE

Beyond the specific drawbacks of the industrial program and the national champions strategy lies a defective approach to designing policy, that is, how the sausage is made. The issue begins with faulty data and extends right through the entire process, from planning to implementation.

Over the past few years, experts have raised serious doubts about the quality and integrity of India’s official data. The most recent budget arrested a growing trend of not recording expenditures on the government’s balance sheet, but even now, the public lacks a clear picture of the country’s overall fiscal position. During the height of the pandemic, scientists repeatedly asked the government for the health data it had collected, but little information was released. Without greater transparency, it is difficult to have confidence that the government is basing policy on good information.

Many policies have also run aground in India’s federal structure. Nearly every major economic issue in India today—agriculture, health policy, power, taxes, welfare schemes—requires joint action by the national and state governments. Yet the national government has often made policy almost entirely on its own, with the result that many initiatives are implemented poorly at the state level. In such cases, policymaking can become trapped in a vicious cycle, in which a lack of trust on the part of the states discourages them from implementing national initiatives properly, thereby eroding the government’s trust and discouraging it from consulting with the states on the next policy measure. The recent agricultural reforms, which were imposed without consultation with the affected states, illustrate the problem.

Even in cases in which reforms have been formulated adequately and implemented properly, many policies have been plagued by a lack of continuity. Often, the government has defeated its own strategic objectives through subsequent measures. For example, actions to improve farm income have been undermined by decisions to ban key exports and limit the amount of food stocks that private firms can hold. The intention to widen the tax base was set back when in 2019 the income tax threshold was raised dramatically, releasing about three-quarters of taxpayers from the tax net. The goal of increasing foreign investment is currently being threatened by proposed rules for online retail that would adversely affect the operations of Amazon and Walmart.

All governments must change their regulatory approach from time to time. But India’s chronic inconsistency means that firms cannot count on the stability of the economic framework: if they invest based on current rules, they may run into difficulty in a year or two, when the rules change. Some may decide it is better not to invest at all. The lack of a clear, stable investment framework is the fundamental barrier to convincing international manufacturers leaving China to relocate their operations to India. And this also explains why foreign direct investment has been flowing into India’s technology sector: because this sector, unlike manufacturing, is lightly regulated and so is not subject to the same degree of policy uncertainty.

A CHANCE TO REBOOT?

If the Indian economy can put the pandemic behind it, the coming year should be a good one. India’s GDP has already regained its pre-pandemic level, and the International Monetary Fund forecasts it will grow by 8.5 percent in 2022, around three percentage points more than China’s. The question is whether the government will be able to use this growth as a springboard to more sustained prosperity, turning India into a global manufacturing center.

A comparison with China is instructive. Compared with China’s, India’s population and workforce are young. And whereas China’s hardware revolution—its huge investments in infrastructure and housing—has largely run its course, India’s is only just beginning. China is also an increasingly authoritarian country and has begun to undermine private-sector entrepreneurship and innovation through sometimes punitive state intervention; India, by contrast, is the world’s largest democracy, with the groundwork in place for an expanding private sector.

For the Indian economy to achieve its potential, however, the government will need a sweeping new approach to policy—a reboot of the country’s software. Its industrial policy must be reoriented toward lower trade barriers and greater integration into global supply chains. The national champions strategy should be abandoned in favor of an approach that treats all firms equally. Above all, the policymaking process itself needs to be improved, so that the government can establish and maintain a stable economic environment in which manufacturing and exports can flourish.

But there is little indication that any of this will occur. More likely, as India continues to make steady improvements in its hardware—its physical and digital infrastructure, its New Welfarism—it will be held back by the defects in its software. And the software is likely to prove decisive. Unless the government can fundamentally improve its economic management and instill confidence in its policymaking process, domestic entrepreneurs and foreign firms will be reluctant to make the bold investments necessary to alter the country’s economic course.

There are further risks. The government’s growing recourse to majoritarian and illiberal policies could affect social stability and peace, as well as the integrity of institutions such as the judiciary, the media, and regulatory agencies. By undermining democratic norms and practices, such tendencies could have economic costs, too, eroding the trust of citizens and investors in the government and creating new tensions between the federal administration and the states. And India’s security challenges on both its eastern and its western border have been dramatically heightened by China’s expansionist activity in the Himalayas and the takeover of Afghanistan by the Pakistani-supported Taliban.

If these dynamics come to dominate, the Indian economy could experience another disappointing decade. Of course, there would still be modest growth, with some sectors and some segments of the population doing particularly well. But a broader boom that transforms and improves the lives of millions of Indians and convinces the world that India is back would be out of reach. In that case, the current government’s aspirations to global economic leadership may prove as elusive as those of its predecessors.