Table of Contents

From the early 1960s to the end of the 1970s, India’s economic growth rate averaged around 3.5 percent per annum. World Bank data show that India’s real gross domestic product (GDP) growth rate in rupee terms averaged 3.5 percent between 1961 and 1980. In the 1980s, the growth rate averaged around 5.5 percent. But even that modest rate proved unsustainable. Toward the end of the 1980s, India had run up a high fiscal deficit, and the country faced an external funding constraint as well. Its meager export earnings were insufficient to pay for short-term external borrowings. Although the episode resulted in the pledging of India’s gold holdings in return for loans from the International Monetary Fund, it paved the way for the removal of the shackles on the Indian economy such as comprehensive industrial licensing, import substitution, and restriction of several items of production for small industries.

In the years that followed India’s balance of payments crisis in 1990–1991, Indian policymakers initiated a slew of measures that sought to reduce the role of government in the economy. The industrial licensing regime was largely dismantled. Financial liberalization, too, was undertaken. The Indian rupee was made convertible on the current account, and the dual exchange rate was abolished. The economic growth rate picked up, but growth was uneven, and economic reforms were pursued in fits and starts—and mostly by stealth. The average annual growth rate in the decade of the 1990s was only around 5.6 percent, not much different from where it was during the 1980s (see figure 1). The growth rate picked up to about 7 percent in the new millennium and continued at that level to around 2008. In the six years since the global recession of 2008–2009, the growth rate averaged about 7.5 percent, mainly because of the massive fiscal stimulus provided by the government in response to the global financial crisis. But that brought in its wake a host of other problems that the economy is still grappling with today. Indeed, in the past twenty-five years, every time India achieved a slightly higher economic growth rate, it was followed by some combination of an external financing deficit, a rise in nonperforming assets in the banking system, a high rate of inflation with consequent currency overvaluation, and other problems. This was the case at the end of the 1970s, at the end of the 1980s, and again in 2012–2013.

Admittedly, India’s situation is not unique. In general, emerging economies, more so than developed ones, are prone to overheating risks because their productive potential and institutional capabilities are still evolving. Latin American nations, with the possible exception of Chile, come to mind. East Asian countries, too, both the so-called Four Tigers (Hong Kong, Singapore, South Korea, and Taiwan) and aspiring economies, suffered an economic crisis in 1997–1998. However, India’s performance is especially disappointing because unlike these other countries India does not even reach the lower-middle-income category. Its scores on World Bank human development indicators lag behind those of many other developing nations. The Indian per capita income level was comparable to South Korea’s in the 1950s and China’s up to the 1970s; both nations have since pulled far ahead of India.

The triad of a trade deficit, nonperforming bank assets, and inflation that has bedeviled India’s growth efforts is expressed on many dimensions and produces ripple effects throughout the economy. The fiscal stimulus of 2009–2011 was followed by the strong reappearance of these effects, but they have been notable at other key points in India’s economic history as well.

Balance of Trade Deficit

India has been mired in a deficit trade balance for most of the decades since independence, though other indicators have had a better performance. According to data from the Reserve Bank of India (RBI), India’s external trade as a percentage of GDP was somewhat healthy in the first few years after the country attained independence (see table 1). It began to decline after that, reaching a low point in the mid-1960s before once again picking up gradually. That trend notwithstanding, India’s merchandise trade balance has been in deficit for the most part of the last fifty-five years, as imports have exceeded exports, with a corresponding outflow of foreign exchange.

Among other policies, import substitution, the requirement for comprehensive industrial licensing, and the reservation of production of many items for the small-scale sector held back the Indian economy from becoming more efficient. Although little is to be gained from reexamining policy choices made in an earlier era by then prime ministers Jawaharlal Nehru and his daughter Indira Gandhi to meet different imperatives, it is a fact that those policies had adverse consequences for India’s productivity and export competitiveness, keeping the economy unnecessarily vulnerable to external shocks related to trading and exchanges. This state of affairs continues to this day.

The protectionist policies emphasizing domestic production through import substitution had an important side effect. Export promotion, in contrast to import substitution, would have de-emphasized domestic consumption, resulting in higher rates of saving and investment. India’s savings rate picked up very gradually, and capital formation in turn was low and slow. Consequently, India did not participate in the huge leap in economic growth and living standards enjoyed by the East Asian economies in the closing decades of the twentieth century. The capital constraint was partially relieved in the early years of the new millennium as both the Indian economy and the world economy enjoyed rapid growth for some time. However, when this growth proved unsustainable, the improvement in India’s savings rate stalled. A low and stagnant savings rate combined with a high incremental capital-output ratio put a cap on the noninflationary (that is, nonoverheating) growth rate that the Indian economy could sustain.

Nonperforming Assets

Episodes of heated growth in India’s economy are typically followed by the emergence of a high level of nonperforming assets in the largely public sector–dominated banking system. Nationalization of India’s banking system, which began in 1969, will soon reach the half-century mark. A dispassionate analysis would find it difficult to declare nationalization a success story, for large sections of the population remain unbanked. The government’s Jan-Dhan Yojana, or People’s Money Scheme, a national mission launched by Prime Minister Narendra Modi in 2014 to ensure that all Indians have access to financial services, especially banking services, seeks to address this particular aspect of the more than four decades’ of failure by government-owned banks.

Among the broader effects of banks’ retention of nonperforming assets is a drop in the credit flow to domestic businesses. In particular, Indian agriculture finds itself in a vicious trap. Credit flow to agriculture remains imperfect and is often impaired, owing to various factors, some within the control of farmers, some not. Furthermore, India’s wealth inequality is among the world’s highest, and the country lacks medium-sized producers—part of the so-called missing middle—in manufacturing; both are testament to Indian banks’ inefficient and distorted credit allocation process.

RBI data on nonperforming assets go back only to 1996–1997 but do tell a story. In the three financial years ending March 1995, March 1996, and March 1997, India recorded real GDP growth rates of 6.6 percent, 7.6 percent, and 7.6 percent, respectively. Since the year ending in 1997, India’s scheduled commercial banks, and particularly the public sector banks, endured a high ratio of nonperforming assets to gross advances. The ratio was in double digits up to 2001–2002. In 1996–1997 it was 15.7 percent (17.8 percent for public sector banks). The problem has resurfaced since the global financial crisis of 2008–2009.

Restructured corporate loans helped bank management understate the extent of stressed assets. The RBI now reports the total stressed assets in the banking system. It is the sum of gross nonperforming assets plus restructured standard advances. On that basis, the stressed advances of public sector banks were high and rising as of September 2015, when they stood at 14 percent of total advances. It is worth noting that private sector and foreign banks had a much lower proportion of nonperforming assets than government-owned banks.

A solution to the problem of stressed assets in the banking system remains elusive, as economic growth is held back by poor global growth, a collapse in commodity prices, and a reduction in global trade flows. Corporations are unable to return to profit and so are unable to service loans. Loan fraud committed by unscrupulous promoters who divert funds from their businesses for personal ends, with or without the connivance of bank officials, is partly responsible for India’s banking crisis. The government, for its part, is constrained to keep an eye on the fiscal deficit ratio in an environment of low growth. Hence, recapitalization is rationed. At the same time, the political environment prevents greater efficiency, an improvement in governance, or consolidation of the banking system.


Household managers know very well that cost-of-living increases erode the purchasing power of their domestic budget and lower their standard of living. They save less and therefore the country as a whole invests less. Like cost-of-living increases, cost-of-production increases weigh on corporate profitability and hence on capital investment by businesses.

Price increases (commonly known as inflation) of all items consumed, whether by households or businesses, have been a persistent problem for India for several decades. Persistently high inflation rates erode the competitiveness of India’s manufacturing and exports. Hence, and contrary to certain economic theories, inflation has been the bane of India’s economic growth.

India’s inflation rate shows little difference before and after the relative opening of the economy in the 1990s. In the fifty-four years from 1960 to 2014, the average inflation rate, measured by the Consumer Price Index for Industrial Workers (CPI-IW), was 7.6 percent, with little difference in average inflation rates before and after 1991. Between 1991 and 1999, bookending the first decade of India’s comprehensive economic liberalization, the CPI doubled, for an average annual inflation rate of around 9 percent. Another doubling of the index occurred between 2006 and 2014. Moreover, the volatility of the inflation rate has come down somewhat since 1990, meaning that the inflation rates have stayed high. It is not surprising that inflation expectations remain perched at double-digit levels. The recent decline in the inflation rate was the result of an extraordinary combination of declining energy prices on the international market and declining food prices, and a tepid domestic economic growth environment with subdued pricing power for sellers. The salience or transience of the lower inflation rate will be tested when India experiences even a brief period of accelerated economic growth.

Some effects have already appeared: even as the GDP deflator entered negative territory, India’s CPI inflation rate began to creep up. In April and May 2016, the month-over-month inflation rate as measured by the consumer price index was more than 1.0 percent. Even though it was explained away as something caused by an increase in food prices, that one-month increase amounts to an annualized inflation rate of nearly 12 percent, and that was in a subdued growth environment. Separately, a Financial Times report filed on January 23, 2016, noted that core inflation (the headline inflation rate minus inflation in food and energy prices) globally was near its post-2000 highs.3 The report singled out India as the country most prone to higher inflation in the second half of 2016.

The persistent problems of inflation, stressed assets in the banking system, and a high merchandise (non-oil, non-gold) trade deficit are symptomatic of India’s underlying inefficient and unproductive economic structure. Indeed, initially, policymakers felt that the period of high growth that India experienced between 2004 and 2008 was the result of a structural transformation of the economy, with improved productivity and capital efficiency. The construction of the Golden Quadrilateral national highway network came to symbolize this transformation and India’s aspirations for economic prosperity. In the end, it proved to be a false dawn. Capital accumulation, more than total factor productivity, had contributed to that growth performance. That is why it ended abruptly in 2008 with the onset of the global recession. India has been unable to reclaim high growth sustainably. The bigger worry is that it may never be able to do so.

To recap, India’s high-growth years of April 2003 to March 2008, during which the compound annual growth rate of the economy in real terms was 8.8 percent, was characterized by several critical inputs that were not sustainable. Domestic credit growth averaged 19 percent and exports grew at 26 percent, gross national savings rocketed from 26.4 percent of GDP in 2002–2003 to 36.6 percent of GDP in 2007–2008, and gross capital formation rose from 25.0 percent to more than 38 percent in the same period.

This scorching pace left an overheated economy with signs of excesses everywhere. Inflation averaged 9.0 percent in 2008–2009, up from 4.0 percent in 2003. The current account deficit had swung from a surplus of 1.3 percent in 2002–2003 to a deficit of 2.3 percent in 2008–2009. Infrastructure developers bid aggressively, and public-private partnerships became the flavor of the times. But as a reminder that “this time is no different,” the tide turned. Asset bubbles got inflated. One of the cheerful arguments was that the financial markets were giving their thumbs-up to the sustainability of the Indian growth story and its long-term economic transformation.

History is replete with examples from across the world that show that when credit is plentiful and the economic environment is irrationally exuberant, finance loses its disciplining powers. Indeed, in advanced economies, even as the ratio of government debt to GDP rose from around 30 percent in 1980 to 105 percent in 2014, the yield on their sovereign bonds fell. The financial markets have seldom provided a check on bad economic policies. Investors lend without exercising due diligence, and investments are made more in hope than after objective commercial consideration. Infrastructure is especially vulnerable to such bouts of financing followed by renegotiations and cancellations. No sustained period of growth can be built on such bubbles.

A comparison can be drawn with China, which, despite its allegiance to the Confucian values of prudence and moderation, has not been exempt from unsustainable growth fueled by credit. Its future is arguably more uncertain because the credit boom in China has been entirely state-directed. That makes relying on market mechanisms to resolve the high debt burden and emerging bad debt loan problem in the banking system considerably more difficult. In fact, China’s growth prospects are much dimmer than India’s precisely because of the enormous accumulation of credit in a short period beginning in 2009 and the government’s role in it. China’s addiction to credit and recourse to credit growth at the first sign of a growth slowdown have not abated. As Michael Schuman has written:

Take Beijing’s often-praised reaction to the 2008 financial crisis. By flooding the country with cash and credit, China pushed growth over 9 per cent through a historic recession. Only afterwards did China’s policymakers realise the potential catastrophe they had spawned. Debt exploded to 248 per cent of gross domestic product in 2014, nearly double the level of 2008, according to IHS Global Insight, a consultancy. Unsold apartments and useless factories stacked up across the land.4

For any economy, not just one of India’s size, a sustained period of high growth requires an almost inexhaustibly large supply of skilled manpower and deep and broad credit markets, a wide industrial base, rapidly expanding infrastructure capacity, and a stable macroeconomic environment. All this must be combined with broad-based income growth, a benign export environment, and political and social stability. On closer examination, the strength of many of these factors in India appears questionable. The following chapter considers each ingredient separately and how much it contributes to or detracts from India’s growth prospects.


3 Steve Johnson, “Global Core Inflation Nears Post-Millennium High,” Financial Times, January 23, 2016,

4 Michael Schuman, “No Need to Idolise China’s Accident-Prone Technocrats,” Financial Times, August 20, 2015,