Friday, October 29, 2010

China: Enormous potential in years ahead

The last year that China’s growth rate was below 7.5 percent was 1990. On a PPP-adjusted basis, Chinese GDP has already overtaken Japan and Germany, making China the world’s number two economy. This impressive growth performance has turned the Chinese economy into an important contributor to global growth, a major force in commodity markets, the most important destination for foreign direct investment and, hence, an emerging power in international trade. Chinese exports and imports in relation to GDP were less than 15 percent in the mid-1980s, but by 2008 had risen to 33 percent for exports and 26 percent for imports. Whereas Chinese exports were less than 1 percent of total world trade in 1984, this share 20 years later had risen above 5 percent. So, if the intent of the strengthened reform effort seen in China in the last 20 years was to contribute to its integration to the global economy, it has succeeded well beyond anyone’s expectations.

The above trends have all contributed to increasing the relative importance of the Chinese economy which, by 2009, accounted for some 7–10 percent of global GDP (the lower range corresponds to market exchange rates). They have also pulled hundreds of millions of people out of poverty, given them enhanced opportunities, and improved living standards, perhaps the most important achievement of the last 20 years.

While the Chinese authorities are to be praised for effective macroeconomic management—sometimes carried out against the background of a difficult international economic environment—it is useful to review briefly the challenges that remain, particularly those that pertain to improving the country’s innovation capacity. In the medium-term perspective, the sources of Chinese growth will gradually shift to technological progress and innovation; thus, it is important to analyze those factors that might be holding the country back. This year’s ICI ranking for China is 64,1 broadly in the same ballpark as that of Mexico, Turkey, and Greece.

Market regulations
The OECD has compiled an extremely useful set of market regulation indicators to “assess the extent to which the regulatory environment promotes or inhibits competition in markets where technology and market conditions make competition viable.”2 These indicators include a measure of the extent of price controls, the licensing and permit system, communication and simplification of rules and procedures, administrative burdens for sole proprietor firms, legal and regulatory barriers, discriminatory procedures, tariff policy, the degree of government control over business enterprises, among others. These are aggregated into three broad families which capture state control, barriers to entrepreneurship, and barriers to international trade and investment. Two major conclusions that are derived from a review of these measures are that

  1. China’s product markets have become increasingly competitive in recent years and market forces are now playing the leading role in the setting of prices and the behaviour of agents in the broader economy;3
  2. China remains a difficult country to do business in; product market regulation is such as to continue to restrict competition in a major way.

Indeed, the OECD data suggests that market regulations are more restrictive in China than anywhere in the OECD countries, including all its transition-economy members. The gaps are large across all three major areas: state control, barriers to international trade and investment, and barriers to entrepreneurship. These results are strongly corroborated by the Doing Business indicators compiled by the World Bank which show poor scores/rankings for starting a business, dealing with licenses, construction permits, employing workers, and paying taxes. The indicators measuring the extent of investor protection are likewise mediocre.

China’s weaknesses in the regulatory and legal framework highlighted by the OECD and World Bank indicators are consistent with members of the business community surveyed in China, who complain of arbitrariness in the application of rules, lack of evenhandedness in the treatment of foreign and domestic investors, and high levels of corruption; the latter is strongly corroborated by a rank of 79 in the Corruption Perceptions Index 2009, which puts China on a par with Burkina Faso and Trinidad and Tobago. A recent report in the Financial Times commenting on the frustrations of doing business in China notes that “the risk-reward calculation between staying quiet and speaking up has shifted towards the latter. With China employing policies including ignoring intellectual property rights, forced technology transfer, and government procurement skewed towards domestic companies, some foreign businesses feel they are being pushed out of the country.”4

Human capital, ICT and R&D
There are a number of other indicators used in the ICI in which China does not score very well, and which thus contribute to dragging its score down. Tertiary enrolment rates of 22 percent are better than in India, but below the majority of countries in Latin America, and below all OECD members, the latter by a significant margin. As might be expected, given China’s stage of development and still relatively low income per capita, the gap is also huge with respect to Japan, Taiwan, Korea, and Singapore. Spending in education, at slightly less than 2 percent of GDP, is also low by international standards. Despite rapid urbanization, China has a sizable rural population engaged in agriculture. Though the literacy rate in the country (93 percent) is well above that of India (66 percent), the fact remains that there are hundreds of millions of people in China who need to be educated and trained to increase their productivity. This will surely be one area where the government will have to do more in coming years, a need made more urgent by China’s rapid integration into the global economy, and a gradual shift in the sources of Chinese competitiveness, from low labor costs and an undervalued exchange rate, to technology and innovation.

As with indicators of education, China, likewise, has mediocre scores in a broad range of indicators that capture the extent of penetration of the latest technologies. As in other parts of the world, progress has been made in recent years in boosting Internet penetration, mobile phone coverage, computer use, access to broadband Internet, and so on. But given China’s large rural population, it is perhaps not surprising that the use of these technologies is still in its early stages. For instance, personal computer use per 100 inhabitants is 5.6, higher than in India (2.8) but about ten times lower than in Korea. China’s rapidly rising income per capita should allow it to narrow these gaps fairly rapidly over the next decade. In the meantime, however, there is little doubt that they slow down innovation capacity.

Research and development expenditure in China is about 1.5 percent of GDP, below the average for the OECD of 2.2 percent of GDP. According to the OECD, if one further looks at R&D spending by industry, the gap with respect to the OECD is much higher, particularly for high-tech industries. This is specially the case for high-tech export industries “which lack a large R&D base in China and continue to rely heavily on foreign-sourced technology embodied in FDI and imported inputs”.5

Improving the social infrastructure
One of the more noticeable trends in China in recent years has been the massive shift of rural populations into urban environments. Whereas in 1980, less than 20 percent of China’s total population of close to 1 billion was living in urban areas, by 2000 this share had risen to 33 percent. The urban population during this period expanded from about 190 million to over 420 million, an impressive growth of over 120 percent. Indeed, at least a few percentage points of the high annual GDP growth rates seen during this period is accounted for by these internal migratory flows, since labor productivity in urban areas is much higher. This trend is expected to continue in coming years and will require careful management. There are several aspects to this.

As is well known, and as in other transition economies, there have been transitory increases in unemployment linked to the inevitable—and much needed—restructuring of the enterprise sector. This has necessitated the introduction of unemployment compensation schemes and, more generally, the buildup of safety nets to mitigate the impact of these adjustment costs on the population, particularly its most vulnerable groups. Like other countries in the industrial world, China will also have to make provisions for its aging population, and more attention will have to be given, therefore, to the development of efficient and modern systems of social protection, particularly pensions. This, in turn, will have implications for the budget. The need for further reforms in this area is highlighted by the fact that by 2030, China’s urban population may well have exceeded 1 billion. Well before the country reaches this threshold, the need for a well-functioning and well-funded social infrastructure will have become a political necessity, especially if the current rural-urban income disparities continue to widen, as they have in recent years. Indeed, China’s political stability will hinge critically on the speed with which the government is able to make progress in this area, at a time when rising protectionist sentiment against booming Chinese exports begins to create a more challenging external environment for the country. An additional benefit of an improved framework for social protection will be that the Chinese population will feel less of a compulsion to save (for old age) and this would stimulate domestic consumption, thereby contributing to reduce China’s huge trade surplus, a constant source of tension with trade partners. Better mechanisms of social protection will also encourage entrepreneurship and long-range planning, key ingredients of successful innovation.

Managing the growth process
For some time now there has been a vigorous debate about the risks that rapid growth rates might pose for macroeconomic stability. Sceptics have pointed out that China’s relatively good inflation performance and some slack in the labor markets suggest that growth could be sustained at the 9+ percent range. However, in recent years, credit growth has at times reached extremely high levels, and a consensus has emerged that managing the growth process in a way that preserves and builds upon the important gains of the past is a key priority for policymakers. This view has been buttressed by a growing perception that rapid growth is leading to a sharp deterioration of the environment, with unforeseen future consequences for public health. However, monetary policy measures—interest rate and reserve requirement increases—are not likely to be enough. There may also be a role for fiscal policies aimed at withdrawing stimulus from the economy. Fortunately, with a low revenue-to-GDP ratio, the authorities have considerable room for maneuver and should not hesitate to use it. Beyond this, further structural reforms, particularly those that boost competition in the economy, reduce the sort of barriers faced by entrepreneurs to start new businesses, and increase transparency and the rule of law will all help to make the Chinese economy more flexible, and will enhance the economy’s productivity and boost its innovation capacity.

The process whereby China plays an increasingly important role in shaping the global agenda will be enhanced if the government sets in motion processes of political reform—the 21st century counterpart of the impressive reforms in the economic area implemented during the past two decades, which have done so much to boost the standards of living of the Chinese population. A China that gradually moves in the direction of giving some political voice to its people can only contribute to enhancing its own ability to nourish an environment conducive to greater innovation.
1. Lopez-Claros, Augusto. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. Organisation for Economic Co-operation and Development (OECD). 2010. Economic Survey: China. Paris. p. 103.
3. ———ibid, pp. 105–7. In 1978, state-owned enterprises accounted for 78 percent of total industrial output and employed 60 percent of the non-farm work-force. “Collectively-owned enterprises accounted for the rest, with no other type of business enterprise permitted at the time.” By 2007, the state controlled 31 percent of industrial output and employed 22 percent of the non-farm workforce.
4. Financial Times, 2010. ‘Foreign Friends’ Lose Reluctance to Criticize China. 20 July. The article quotes an official at the US Information Technology Industry Council saying that “We are feeling less and less welcome in China, which is why you are seeing more people speaking out and reconsidering their futures in China.”
5. OECD, op. cit., p. 25.

Friday, October 22, 2010

Sweden: Why is its innovation outlook so bright?

An impressive performance
Sweden was the top-ranked country in the 2009—and now just recently in the 2010—edition of the Innovation Capacity Index,1 because it does exceptionally well in all the areas captured by the Index. Sweden is an exceptionally good performer, very often placing in the top ranks in those areas identified as being particularly important to assessing innovation capacity. Indeed, Sweden has a rank of number one among 131 countries in transparency and judicial independence, corruption perceptions, gender equity, e-government readiness, personal computer penetration rates, receipts of royalties and license fees, as well as the “doing business” indicators for the time and number of procedures required to register property. It has a rank of 2 in scientific and technical journal articles per capita, environmental sustainability, and research and development expenditure in relation to GDP, where it is second only to Israel. There are 12 other indicators in which Sweden has a top 8 rank, including the quality of its public administration, the effectiveness of its government, rule of law, the more egalitarian distribution of national income, Internet penetration rates, as well as other indicators of good governance.

Sweden’s rank is richly deserved. It is a country that has had an extremely virtuous fiscal policy for the past decade, running budget surpluses with the aim of saving resources to deal with the long-term effects of population aging, but also generating, in the short term, substantial resources to invest heavily in knowledge and training, to earn a top position in terms of labor productivity growth among high income countries. On a per capita basis, Sweden has the largest university system in the world. According to the OECD, “Swedish research is, in relation to the size of its population, leading in the world in terms of scientific output, measured by the number of publications in internationally acknowledged scientific journals.” Sweden is also a leader in terms of patent registration.

Openness and transparency
Sweden has in impressive record of openness and transparency in government. It has put in place comprehensive safety nets which provide security to vulnerable groups in the population. It has thus been able, during periods of economic stress—such as in the context of the 2008–09 world financial crisis—to shelter its population from the effects of the global economic slowdown. Since it also has levels of public debt that are well below those prevailing among competitor countries, Sweden has greater flexibility when it is time to provide fiscal stimulus.

Women in Sweden have access to a wider spectrum of educational, political, and work opportunities and enjoy a higher standard of living than women in other parts of the world. They also have achieved the highest echelons of political power and have an important presence in the business world. Sweden is also an egalitarian society with a more even income distribution than most countries in the OECD and, thus, a strong sense of solidarity and stable labor relations. The country has also achieved an enviable record in terms of caring for the environment; it ranks second in the world in the Environmental Sustainability Index.

Sweden’s public sector is highly qualified and enjoys unusually high degrees of credibility with the business community and civil society. Although the country has high tax rates, there is no evidence that this has discouraged entrepreneurship and innovation. More likely than not, this reflects the fact that the relatively high levels of revenue collection are then reinvested in the economy at large in education, infrastructure development and modernization, public health, and other components of the safety net, as well as training and other productivity-enhancing initiatives, all of which are directly beneficial to the private sector. Having an honest public administration—as demonstrated by Sweden’s privileged and consistently high rankings in Transparency International’s Corruption Perceptions Index—suggest that what matters is not whether tax rates are high or not, but rather whether the government uses the taxes collected in ways that will be productive and that will boost its credibility with economic agents.

A leader in ICT
The government has also played an important catalytic role in encouraging the use of the entire spectrum of information and communication technologies, as made clear by the very high penetration rates of mobile phones, computers, broadband, and the Internet. Not only does the government spend generously in research and development (particularly through institutions of higher education), but the Swedish business sector has also been a driving force in R&D spending, particularly in the telecommunications and pharmaceutical sectors. Sweden has benefited from an economy that, according to the OECD, is dominated by public-private partnerships between manufacturing groups that allocate considerable resources to R&D on the one hand, and public agencies and companies, on the other. This has led, in turn, to the emergence of a manufacturing sector that spans “all of the high-technology and medium high-technology industries”.2

A virtuous cycle of development
Sweden is likely to retain a privileged position in future editions of the Innovation Capacity Index. A combination of solid institutions, good policies and a public administration strongly committed to the idea of building upon past achievements has pushed the country into what one might call a virtuous cycle of development. Successive governments have implemented policies whose primary motivation has been the public good. This in turn has transformed the business community and civil society into active, well informed participants in the shaping of public policies. Just as citizens and corporations pay their taxes because the benefits of doing so are tangible and transparent, governments have been empowered to focus their energies and talents in devising innovative ways to improve the quality of governance. Sweden and its Nordic neighbors provide a useful template for other countries to examine, and, where feasible, to emulate. There is much in their approach to development—combining key elements of modern capitalism without some of its excesses, with a strong commitment to social policies that are fundamentally egalitarian in nature—that is worthy of close examination and study.
1. Lopez-Claros, Augusto. 2010. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. Organisation for Economic Co-operation and Development (OECD) and European Communities. 2005. Oslo Manual: Guidelines for Collecting and Interpreting Innovation data, Joint Publication of the OECD and the Statistical Office of the European Communities. p. 190.

Monday, October 18, 2010

Russia’s unfulfilled potential

Russia is in many ways a unique case, with a relatively mediocre ranking of 56 on the Innovation Capacity Index (ICI),1 well below the rank of countries such as Chile (31), Malaysia (39), and Poland (40), which share broadly similar levels of income per capita. Russia has a solid human capital endowment, reflecting decades of investment in education in science and technology. If Latin America has a grand total of three Nobel Laureates in science, there are at least ten Russian Nobel Laureates in physics alone. And had Alfred Nobel created a category for mathematics, there is little doubt that Russian mathematicians would have been awarded many prizes, perhaps more than any other nation. At the same time, however, it is a country where there is a huge gap between the stock of resources spent in past decades to foster contributions to knowledge, on the one hand, and, on the other, the kind of output that we would normally recognize today as reflecting achievements in scientific innovation, such as, for instance, patent registration or the presence of identifiable Russian brands in manufactured exports. Soviet technology was able to send the first man into space; it made significant advances in nuclear energy technology; but the context of the Cold War and the inefficiencies of central planning misdirected vast resources to the military-industrial complex, at huge cost in terms of living standards. By the time the Soviet Union collapsed in 1991, it was producing large nuclear submarines, MIG aircraft, and other weapons (sold on credit to its allies in the developing world), but not many consumer goods, and few, if any, manufactured goods with even minimal presence in the global economy. The 1990s witnessed a disorderly transition to a sort of market economy which involved redeployment of labor from the military-industrial complex and other heavy and inefficient industries to the private non-defense sector, particularly light manufacturing, services, and other industries long neglected under the state planning system.

A difficult business environment
There are several factors that help explain the persistence of this gap between its relatively solid educational base and Russia’s notable absence among international innovators. First and foremost, 19 years into its transition, Russia has still not established a particularly nurturing business environment. In fact, a case can be made that in some areas, such as levels of corruption, the property rights climate, the lack of independence of the courts, the general level of transparency in the public sector, and in the relations between the government and the business community—what the OECD calls “framework conditions” but which fundamentally refer to the stability and efficiency of the institutions that underpin the market economy—Russia is worse off today than it was six years ago.

This is certainly made unambiguously clear from the good governance indicators compiled by the World Bank and used in the institutional environment pillar of the ICI, as well as by Russia’s embarrassingly low rankings in Transparency International’s Corruptions Perceptions Index—147 among 180 countries in 2008, a drop of 61 positions since 2003.2 Russia’s deteriorating property rights climate, including for intellectual property, is particularly noteworthy—piracy is rampant in Russia—and perhaps more than any other indicator suggests the severe obstacles which at present exist for the creation of an institutional framework that will encourage innovation.

The high incidence of crime and corruption (ranging from “visits” from tax and fire inspectors to politically motivated expropriations by the state) remains a heavy burden on businesses, imposing heavy costs on them, and, therefore, undermining the ability of Russian companies to compete abroad.3 Accounting and auditing standards are weak, raising yet another set of concerns about the investment climate. Increasing restraints on freedom of the press highlight the risks for the abuse of power, and the difficulties for civil society to emerge as a constructive counterweight to the growing power of the state. The World Bank’s Doing Business Report (which provides the indicators that go into the regulatory and legal framework pillar of the ICI) paints a rather uncharitable picture of bureaucracy and red tape in Russia: from rigid labor-market laws and mind-numbing obstacles to the obtaining of licenses—it takes 54 procedures and an average of 704 days to obtain one, at a cost of close to 3,800 percent of income per capita—to difficulties in the payment of taxes and to impediments to international trade. Trading across borders is so laden with red tape in Russia that the country ranks 155th among 181 countries in this particular indicator of the Doing Business Report. This is a particularly perturbing indicator, given the need to encourage exports other than resource-based commodities, on which the Russian economy is totally dependent. According to the OECD, the share of high-value added goods in manufacturing exports from Russia to OECD countries is less than 1 percent and is even lower (0.2 percent) in the case of ICT goods. (In Taiwan, in contrast, close to 50 percent of manufactured exports are high-tech exports).

Innovation policies
These extremely unfavorable business environment conditions have had a number of undesirable repercussions. The country is a major exporter of talent. Not surprisingly, capable Russian researchers with a modicum of ambition emigrate at the first available opportunity. There is no significant engagement between the scientific community and the business world. The sort of collaboration and interaction between institutions of higher education and the enterprise sector which have been so instrumental in the development of a vibrant ICT industry in Israel and Taiwan is largely absent in Russia. State funding for research and development to institutions of higher education accounts for less than 5 percent of total state funding to such institutions. This, in turn, means that state funding to science does not play the catalytic role that it has played in other countries to spur innovation. Instead, as noted by the OECD, the emphasis on “institution-based financing tends to protect incumbents and creates few incentives to increase efficiency, productivity or innovation. On the contrary, since much funding is ‘cost-based’ and allocated with reference to employment levels and fixed assets, greater efficiency could lead to loss of funding”.4

The government has attempted to steer policies in the direction of better support for R&D, with the aim of encouraging the emergence of a culture of innovation. It is aware that while levels of overall R&D spending are not low by emerging market standards, such spending remains unduly concentrated on a few sectors, and consists overwhelmingly of state funding, in sharp contrast with other countries, where much of R&D spending comes from the private sector. One way in which a better balance could be achieved in this area would be to phase out fiscal disincentives to enterprise R&D spending through accelerated write-offs. A law passed in June of 2005 on Special Economic Zones was intended to contribute to diversification of Russia’s industrial structure and to stimulate innovation. Unfortunately, Russia does not have a good history with such special zones, although they have been a staple of Russian structural reforms since the 1990s. In the specific case of the 2005 law, we are skeptical that it will have the desirable effects—particularly in terms of attracting foreign investment, as Taiwan and Israel have been brilliantly successful in doing—given that “disputes concerning the creation and operation of SEZs are to be settled in Russian courts under Russian law”.5 In the absence of mechanisms of international arbitration, it is unlikely that foreign investors may want to expose themselves to the lack of independence and arbitrariness of Russian judges and courts and, more generally, to the primitive, opaque nature of the Russian legal system.

Low ICT penetration
Finally, Russia does not do as well as might be expected in the ICI because, with the exception of mobile telephony, it does not have particularly impressive penetration rates for the latest technologies. Even in the area of personal computers—where notable progress has been made in recent years in terms of expanding their use in businesses and households—PC use per 100 inhabitants is about 13.3, putting Russia in 56th place in the world, slightly worse than its rank of 52 in 2006, and broadly in the middle among the 131 economies covered in the ICI. Similar results hold for Internet use: improvements with respect to the recent past, but absolute levels that are not high enough to put Russia above its 64th place in the world.

Other weaknesses undermining innovation potential
Other factors are likely to complicate the authorities’ attempts at boosting innovation capacity over the medium term: first is the weakening of a culture of meritocracy in the public sector, with many senior positions in government now going to people with links to the security establishment, who increasingly—and presumably without the required qualifications—find themselves running large state enterprises in the energy and other sectors; second, the return to old authoritarian traditions which sit uncomfortably with the openness and willingness to “challenge the system” that are so common in successful cases of innovation; third is the country’s long-term demographic trends, which foresee a rapidly aging and declining population, limiting the role of the labor force as an engine of economic growth in coming years; finally, an ambivalent attitude toward foreign direct investment, which is welcomed one day, but quickly followed by “renegotiations” of previously agreed contracts with foreign partners, all of this accompanied by the return of old fashioned ideas about “strategic sectors” which should remain under state control. This has led to a marked increase in the presence of the state in the energy and raw materials sectors. Furthermore, the 2008–2009 financial crisis led to a close to 8 percent drop in GDP growth in 2009, and a massive widening of the budget deficit, creating a likely setback for the government’s efforts to do more in this critically important area. The sum total of the above suggests that Russia is a classic case of unfulfilled potential—a giant still playing in the little leagues.
1. Lopez-Claros, Augusto. 2010. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. In fact, between 2003 and 2008, Russia has been one of the world’s worst performing countries in the
Corruption Perceptions Index, sharing (undistinguished) company with the likes of Belarus, the Islamic Republic of Iran, Sudan, Uzbekistan, Syria, and Gambia. China’s rank fell from 66 to 72; India’s rank moved from 83 to 85, and Brazil’s from 54 to 80, with Russia having, by far, the worst performance among the largest emerging markets.
3. According to Richard Pipes, “Russia’s Pride Could Diminish Its Power.”
The Wall Street Journal. 24 August 2009: “One of the major obstacles to conducting business in Russia is the all-pervasive corruption. Because the government plays such an immense role in the country’s economy, controlling some of its most important sectors, little can be done without bribing officials. A recent survey by Russia’s Ministry of the Interior revealed, without any apparent embarrassment, that the average amount of a bribe this year has nearly tripled compared to the previous year, amounting to more than 27,000 rubles or nearly US$1,000. To make matters worse, business cannot rely on courts to settle their claims and disputes, and in extreme cases resort to arbitration.”
4. Gianella, Christian and William Tompson. 2007. “Stimulating Innovation in Russia: The Role of Institutions and Policies.” Economics Department Working Paper. Paris: OECD. p. 20.
5. ibid. p. 27.

Tuesday, October 5, 2010

India: Priority areas for boosting innovation capacity

Viewed in a long-term perspective, India’s recent economic performance has been quite impressive. According to the OECD, GDP per capita has accelerated from 1.2 percent in the 30-year period to 1980 to 7.5 percent currently, a growth rate, which, if sustained, would double income per capita in a decade. This is clearly an important achievement that has brought with it a substantial reduction in the incidence of poverty, from 36 percent in 1994 to some 27 percent by 2005.1

Inevitably, the global financial crisis has contributed to a deceleration of India’s economic growth in 2008 and 2009, and the emergence of other problems, such as a substantial widening of the budget deficit. However, assuming this to be a temporary phenomenon, the key question for Indian economic policy for the foreseeable future will be what policies will allow it to sustain or, indeed, accelerate its growth performance over the next decade. Just as China has benefited from a massive process of urbanization in the past two decades which has contributed in an important way to its high economic growth rates, India has a similar structural feature: favorable demographics, which is likely to fuel growth. For the next 20 years, the share of the working age population will rise, and India will have to find ways to bring its masses of young people into the mainstream by spending on education and improving the quality of its educational institutions, in order to boost the productivity of its young, particularly the poor.

There has also been a significant improvement in recent years in the quality of India’s policy environment and the degree of sophistication of its private sector. In those areas in which the government has decided to open up participation to the private sector—telecommunications, civil aviation—the response has been impressive. According to the OECD, India’s telecommunications sector has become the third largest in the world. In contrast, in electricity generation, where public enterprises are still dominant, shortages are common, and there is a serious problem of non-payment due to “poor management of distribution enterprises and a failure to eradicate theft” (OECD, 2007). There would thus appear to be wide scope for gains in efficiency in resource allocation in India, with corresponding gains in productivity and economic growth.

India does not do well in the Innovation Capacity Index, with an overall ranking of 85 among 131 countries. Looking at the various pillars of the ICI, India’s worst ranking (94) corresponds to human capital, training, and social inclusion, followed by adoption and use of information and communication technologies (93). To boost its capacity for innovation, policymakers in India will have to address a number of important weaknesses, of which the most important are discussed below.

Education and labor market
India continues to have high illiteracy rates—its rank in the ICI on this particular indicator is 110—suggesting that illiteracy still afflicts several hundred million people, not surprisingly a serious blight on innovation capacity. School enrolment rates remain low by international standards, with its rank for secondary school level an unimpressive 94. The scope for improvement in girls’ education is especially intense—the ICI attaches to India a rank of 89 on the gender equity index. Given the wide range of positive payoffs associated with improvements in girls’ education and, more generally, gender equity, much more will have to be done over the longer term to integrate women into the economy, the educational system, and India’s political establishment. India will also have to educate and train its young poor, to enable them to join the labor force with usable skills, particularly in those sectors with potential comparative advantage. There is every expectation that world demand for out-sourcing will rise in coming years, reflecting the continued shift of backroom operations associated with further reductions in the cost of communications. For India to be able to take full advantage of these opportunities, it will have to improve the level of skills and training of its workforce. In this respect, it is particularly worrying to see that India suffers from huge inefficiencies in its labor market, with laws governing regular employment contracts much stricter than in many emerging markets, and in virtually all members of the OECD. As noted by the OECD, one major reason for this is “the requirement to obtain government permission to lay off just one worker from manufacturing plants with more than 100 workers.” Not surprisingly, a rigid labor market will prevent India from deriving the full benefit of its comparative advantage in labor-intensive industries.

A serious fiscal deficit problem
For many years now India has had a serious problem with its public finances. Essentially, it has been running deficits of some 6-10 percent of GDP for the past decade, among the highest in the world. This problem has many dimensions and it is worthwhile to highlight several here. First, India’s public debt level, at 83 percent of GDP in 2009, is already very high by international standards; indeed, it is larger than that of Brazil and Argentina, twice that of Turkey, four times that of China, and well over ten times larger than that of Russia, as well as of most OECD countries. Second, with total revenue collection in the neighborhood of 18 percent of GDP (again, extremely low by international standards) due to its very narrow revenue base—the central government collects no more than about 11 percentage points of GDP in taxes—the revenue-to-debt ratio is among the lowest in the world.

In an attempt to bring about some measure of medium-term fiscal adjustment, the government brought into force in 2003 a Fiscal Responsibility Budget Management Act (FRBMA) which established a path of deficit reduction through 2009. The high economic growth rates during the period 2004–07 boosted government revenue and some progress was made in reducing the deficit, but the 2008 financial crisis and the need to respond to the weakening of economic activity through fiscal stimulus means that the deficit in 2009 will be back to some 10 percent of GDP. In any case, the law has generally applied to the central government only, whereas, in fact, a large share of the deficit problem is with the states. Moreover, it does not contain a medium-term debt target that might act as a binding constraint on the public finances. The law also does not establish any penalties or sanctions for departures from the path of fiscal adjustment laid down in the FRBMA. According to the IMF, “despite the apparent consolidation, off-budget activities increased, deadlines to comply with fiscal targets were extended and the fiscal adjustment was not underpinned by expenditure reform.”2 India’s fiscal situation is, without doubt, a severely limiting constraint on the country’s ability to boost its innovation capacity.

A large public debt constrains the ability of the government to allocate greater resources to education and public health, and to improve the country’s dilapidated infrastructure, all areas where India, as noted earlier, is lagging behind. The inability of the government to introduce expenditure reform is, likewise, a major constraint on policies that might seek to direct greater resources to more productivity-enhancing areas. This year, India is spending close to 4 percent of GDP on regressive subsidies on petroleum, diesel, and various other products, a sum roughly equivalent to what it spends on education and health combined. This is a shocking statistic that highlights the significant need to improve the macroeconomic environment.3 Without doubt, the deficit is a drag on the economy. A much lower deficit would have been associated with higher growth rates and higher levels of revenue, which would have boosted the ability of the government to respond to pressing social needs. Not doing business It takes 13 procedures, a total of 30 days at a cost of 70 percent of income per capita to open up a business in India. In the World Bank’s Doing Business Report 2009, India ranked 121 (among 181 countries) in this indicator, representing a drop of seven places with respect to 2008. Among the 131 countries ranked in the ICI, India has a rank of 100 for the cost of registering property, a rank of 116 for the ease of pay-ing taxes, and a rank of 180 for enforcing contracts. The fact is that bureaucratic red tape and excessive regulation remain serious problems in India, a country afflicted with a pervasive culture of government intervention and control, which adds to business costs, discourages the development of small and medium-sized enterprises, and, given the important role played by entrepreneurship in most forms of innovation, is thus a heavy burden on India’s innovative capacity.
1. This progress notwithstanding, China has grown more quickly than India over the same period and, consequently, has seen much faster reduction in poverty levels, regardless of the poverty line chosen. China has much lower infant mortality, higher life expectancy, and lower illiteracy rates than India.
2. International Monetary Fund, 2009b, India: Selected Issues. International Monetary Fund Country Report No. 09/186. June. p. 34.
3. There is yet another dimension to the fiscal deficit problem which will not be addressed here, having to do with the impact of debt financing on the financial system; it is much easier for the banks to lend to the government than to lend to small and medium-sized enterprises, which are so much at the center of the innovation chain in other countries.