Why India Lags Behind China

The prime minister at a conference of business leaders held some time back enquired why democratic India was not getting as much direct foreign investment as communist China particularly as it had the advantage of the English language and the rule of law. He asked for an explanation and suggestions for government action. Here are some.

China and India are attractive to foreign investors because of their relatively skilled but cheap labour for manufacturing industry particularly for exports. The cost of industrial labour depends, however, not only on the wage paid but also on the hidden costs associated with various rights attached to employment that public policy might have created. This matters. Unlike labour that is casually hired, the relationship between an industrial worker and his firm is more long-term because industrial jobs require on the job training of workers which create skills which are specific to the firm and thus valued by it, but are of no value outside the firm and hence of no particular value to the worker. This gives a bargaining edge to industrial over casual labour, and also provides the opening for opportunist behaviour particularly in combinations such as trade unions to raise the price it can command. It also leads to industrial practices like paying a premium to more experienced workers with equivalent formal skills, and in recessions of first laying off workers who were hired last (the so-called LIFO principle).

 

This bargaining power and the asymmetry in the differing value of different types of workers to the firm leads to the differentiated wage contracts found in competitive markets for industrial labour (of the same skill) as compared with the more uniform wages for casual labour.

In countries like India or China with large numbers seeking the relatively attractive jobs offered even for the lowest skills in industry, such cost-increasing opportunism will also be controlled in a relatively free industrial labour market because employers can hire and fire workers. But public policy can curtail this freedom, as it has in many countries, through labour laws supposedly to protect `labour. But the net effect of such laws is not to `protect labour in general, but rather, by raising the cost of labour well above its true opportunity cost as economists call it to create a small labour aristocracy of insiders who have `protected industrial jobs, and the millions of outsiders who are prevented from acquiring one by bidding against their privilege fellows.

The future job prospects of outsiders will be further damaged by two other consequences of the artificial raising of the cost of industrial labour: (a) by reducing its return, the level of industrial investment and thence the number of future industrial jobs will be lower, (b) the rise in its relative price will lead employers to economise on labour by substituting machines for men in both current and future production.

This apparatus is sufficient to explain why India has attracted so much less foreign investment than China. After their `independence in the 1940s, both countries inherited or adopted extreme forms of public `protection of labour which in India, unlike China, only applied to the so-called organised industrial sector. In Chinas communist system all labour was employed by the state. In the politically-determined system of payment that was created, the economic considerations which determine the structure of industrial wages in a free labour market were eschewed. The deleterious effects of this communist economic system on efficiency and hence the productivity and growth rate of the economy are well known, and it was its de facto repudiation in the special economic zones of southern and parts of north-eastern China, which has led to the miraculous growth rates of the Chinese economy since the mid-1980s.

For investments in the non-state sector, China has, in effect, created a completely free labour market, where the employers do not have to adhere to any of the labour practices particularly concerning the freedom to hire and fire workers which still hamstring the state enterprises. The resulting low costs of obtaining a disciplined though low skilled labour force have proved attractive to foreign investors particularly the ethnic Chinese of Hong Kong and Taiwan who have poured in billions to set up all sorts of relatively labour-intensive export industries which are now moving to China not only from the industrialised West, but many of its neighbouring NICs.

The situation could not be more different for a foreign investor seeking to set up manufacturing operations in India. Indias labour laws are some of the oldest in the world. They date to 1881. They were instituted by the Raj, just a few years after they had been adopted in Britain which was by then already an industrialised country. By the late 19th century, industrialisation in India was well under way with the textile industry in particular having succeeded in turning the tables on Manchester. In fact, it was a combination of agitation by ignorant English philanthropists and grasping English manufacturers, as one economic historian puts it, which led to the institution of the Factory Acts in India. They have hobbled Indian industry ever since. The Indian textile industry was an early victim, being overtaken first by the Japanese at the turn of the century, and more recently by the South-east Asian NICs. Then with the establishment of the permit raj, and the virtual elimination of any exitforso-called `sick industries, further inefficiencies were introduced into Indian industry.

But the Chinese `solution is not open to India, because of the two distinguishing features noted by the prime minister its legal and democratic systems. India cannot just turn a blind eye to existing labour laws for new investments as the Chinese have done, because this would be rightly challenged in the courts. Nor, given its democratic political system can it just change the law by fiat as the Chinese communists could but refrain from doing for ideological reasons. But unless these imperialist labour laws are democratically repealed, Indian industry will continue to be hobbled by them as it has for nearly a century. Nor will foreign investment flow in the amounts it could into India and as it has into China. Continuing to protect a small aristocracy of industrial labour means hurting the prospects of prosperity for the mass of Indias labour. It is time to repeal this imperial legacy.

( Deepak Lal is James Coleman Professor of International Development Studies, University of California, Los Angeles)