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Ajit Ranade: Lewis, labour and currency

The demographic window which is closing for China won't be open for India for too long

Ajit Ranade 

In 1954, Sir Arthur Lewis wrote a paper entitled “Economic Development with Unlimited Supplies of Labour”, which has had a lasting influence on the way we understand economic development. He wrote this paper while he was at Manchester, but subsequently moved to the West Indies, where he was born, and was later awarded the Nobel Prize in 1979. The Lewis model of economic development postulates two sectors, the subsistence and the modern. This has often been interpreted as agriculture and industry, although Lewis himself meant a broader class of subsistence, which included agricultural labour, the urban poor, domestic servants and so on. This is the reservoir of surplus labour whose low wage prevails across the economy and in the industrial sector as well. The capitalist industrial sector develops rapidly by drawing on this infinite supply of very cheap labour. There is continuous labour migration from the traditional to the modern sector (read from “rural to urban”). Wages remain constant and low for long periods of time, and economic growth occurs as the rising share of profits gets reinvested. In the Lewis model, eventually the reservoir of cheap labour gets exhausted, capital accumulation slows down and wages get determined by marginal productivity as in standard economic textbooks.

The Lewis model is more than 50 years old, but it has been eminently validated by the experience of development of many countries in Asia and Africa. Even though abstract and skeletal, the model seems to be an accurate description of China’s growth experience of the past two decades, including the last bit about eventually declining labour supply.

In China’s case, growth and development did not arise out of a mechanistic market process, but was aided by conscious government policy backed by a political and economic vision. Thus, it was not only the near-zero constant wage postulated by Lewis, but also cheap capital, cheap raw material, cheap energy and a cheap currency.

Industrial growth benefited from these artificially inexpensive inputs, supplemented by the setting up of special economic zones with completely flexible labour laws (which were the inverted form of labour laws outside the zones). Added to all these ingredients was a hefty dose of pragmatism, which constantly fine-tuned policies to adapt to changing global conditions.

As anticipated in the Lewis model, Chinese growth brought immense benefits to the “capitalists”, i.e. the investors in industrialisation, but workers’ share declined, in relative terms. Since the currency was also kept undervalued, the workers’ quality of life could not benefit even from cheaper imports. Thus the improvement in living standards of workers is less spectacular than that implied by sustained double-digit growth of the economy. The zero population growth should have implied a much more rapid growth in per capita terms, which is not the case. This may be one reason why the share of domestic consumer spending in the Chinese economy is still quite low at around 38 per cent. Since the growth process employed hundreds of millions of workers, this sacrifice of each worker was small, mostly hidden and diffused. Besides, what the worker was getting in the industrial sector was above the subsistence wage anyway, so why should they complain?

China’s destiny is determined by its demography, if not only by the Lewis model. The infinite reservoir of China’s labour shows signs of running dry. Rural wages have risen, and standard of living in the hinterland has also improved, thanks to the spread of infrastructure, health and education facilities. The incremental wages of Shenzen or in the industrial clusters of the Pearl River Delta no longer seem attractive enough for rural folk to migrate. The rural folk themselves are ageing. The share of younger cohort of 15 to 24 years is declining, and will be just 12.6 per cent by 2020. It is the youngsters who tend to migrate, and their numbers are dwindling. The share of working age population itself will stabilise and start declining in the next decade.

Thus, the infinite supply of labour is now very much finite. That limited supply is beginning to pinch, and this partly explains the steep wage hikes announced recently by electronics and auto companies.

There are several signs of worker unrest caused by low wages and working conditions. There are signs that workers may assert their rights in collective bargaining as well. From emerging shortage comes their power.

Just like the end of cheap labour, there are signs of the end of cheap currency. Consistently large export surpluses have not managed to lift the renminbi. This was because of the infinite capacity of the Chinese central bank to buy dollars and prevent appreciation of their local currency. That infinite capacity (a la Lewis) is also ending. The central bank’s determination to keep the yuan undervalued may be slackening due to domestic inflation pressures, and also due to international pressure to revalue. The Americans and Europeans have complained for long about the imbalance caused by Chinese surplus. An exchange rate reform announced this week by the Chinese central bank is nothing radical but takes some steam out of G20 pressure on China. And most of all, it smells of pragmatism. It is similar to the one announced in 2005 (itself in response to foreign pressure), and nothing much came out of that.

As China chugs into its demographically destined territory, its journey has implications for India’s industrialisation policy. Over past 20 years, the share of India’s industry has remained constant at around 20 per cent. Large growth in industrial output and employment is missing. It is not as if the Lewis model has bypassed India, but India’s policy constantly seems to thwart Lewis. It could be labour laws which prevent large-scale flexible employment. It could be small scale reservation, which thankfully is reducing. It could be the fragmented fiscal federation which denies us a fully integrated common economic market. It could be inadequate financial inclusion which keeps many micro, small and medium enterprises excluded from finance. Or it could simply be due to the fact that our polity is very different from China’s. But the fact is that the demographic window which is closing for China won’t be open for India for too long. And we don’t want to be the economy which disproved Arthur Lewis!

The author is chief economist, Aditya Birla Group. Views expressed are personal

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First Published: Tue, June 22 2010. 00:52 IST