A decade ago, India and China had roughly the same gross domestic product per capita. But at $440, India's current GDP per capita is only about half of China's, and India's GDP is growing at a rate of only 6 percent a year, compared with China's 10 percent. That 6 percent is no mean feat, but could India grow faster?

Over the past 16 months, the McKinsey Global Institute (MGI) has studied the country's economy to see what is holding it back and which policy changes would accelerate its growth.¹ We studied 13 sectors in detail—two in agriculture, five in manufacturing, and six in services. Together, they account for 26 percent of India's GDP and 24 percent of its employment. (We also drew on similar MGI studies carried out in 12 other countries, including Brazil,² Poland,³ Russia,⁴ and South Korea.⁵)

Our study found three main barriers to faster growth: the multiplicity of regulations governing product markets, distortions in the market for land, and widespread government ownership of businesses (Exhibit 1). We calculate that these three barriers together inhibit GDP growth by more than 4 percent a year. Removing them would free India's economy to grow as fast as China's, at 10 percent a year. Some 75 million new jobs would be created outside agriculture—enough not only to absorb the rapidly growing workforce but also to reabsorb the majority of workers displaced by productivity improvements.

Can these barriers be dismantled? We believe that they can if India's policy makers choose a deeper, faster process of reform than they have implemented so far.

Barriers to productivity growth

Regulations governing product markets, land market distortions, and government-owned businesses—the three main barriers to India's economic growth—have their depressing effect largely because they protect most Indian companies from competition and thus from pressure to raise productivity. Countries with the highest productivity have the highest GDP per capita (Exhibit 2) because the amount of goods and services each worker produces is the key determinant of a country's GDP per capita.

Product market barriers

Taken together, the rules and policies governing different sectors of the country's economy impede GDP growth by 2.3 percent a year. India's liberalized automotive industry shows what could be gained by removing these rules and policies. The Indian government, as part of its 1991 economic reforms, relaxed licensing requirements for carmakers and restrictions on foreign entrants into the industry. Competition increased dramatically, and the old, prereform automobile plants lost substantial market share. But demand for new, cheaper, and higher-quality Indian-made automobiles soared, so that employment in the industry rose by 11 percent from 1992–93 to 1999–2000 despite productivity growth of no less than 256 percent during the same period.

India's current policy regime, at the sector level, has five features that are especially damaging to competition and therefore to the productivity of the country's industries.

Unfairness and ambiguity. Many policies restrict competition because they are inequitable and ill conceived. In telecommunications, for example, privately owned entrants must pay heavy fees for licenses to operate in prescribed areas, while government-owned incumbents pay no such fees and are at liberty to offer local-access and wireless services nationwide. Moreover, the rules concerning access to other operators' networks are unclear, and incumbents have used this ambiguity to delay the start of the privately owned entrants' operations. Indeed, these regulatory anomalies protect incumbents from competition by deterring some private telecoms from entering the market at all.

Uneven enforcement. The rules are not applied equally to all companies. Subscale steel mills, for example, frequently steal electricity and underreport their sales to avoid taxation. Larger, more visible players can't get away with such irregularities, so the less productive companies survive by competing unfairly (Exhibit 3).

Products reserved for small enterprises. Some 830 products are currently reserved for manufacture by firms below a certain size. Producers of certain types of clothing and textiles, for instance, face limits on their spending for new plants—limits that protect clothing makers that are below efficient scale. As a result, typical Indian clothing plants have only about 50 machines, compared with more than 500 in a typical Chinese plant. Restrictions on imports of clothing from more productive countries protect the domestic markets of these subscale Indian players.

At present, moreover, their exports are protected too. Several countries, including the United States, import a guaranteed quota of Indian clothing each year. Not surprisingly, India's share of garment imports in countries without such quotas is much lower than it is in quota countries. As all such quotas are to be removed over the next five years, Indian exports will be highly vulnerable unless the sector can become more productive (Exhibit 4).

Restrictions on foreign direct investment. Certain sectors of the Indian economy—retailing, for example—cannot receive foreign direct investment, and this prohibition closes off a fruitful source of technology and skills. Best-practice global retailers, whose international experience helps them to build operations quickly by tailoring their formats to local environments, have enabled the retail sectors in Brazil, China, Poland, and Thailand to develop rapidly. Foreign retailers also prompt local supply chains to improve by stimulating investment and productivity growth in food processing and wholesaling, for example. Together with land market reforms (discussed later), allowing foreign direct investment in food retailing would make it possible for India's supermarkets to increase their market share to 25 percent nationwide in ten years, from 2 percent currently, and to offer prices that would on average be 9 percent lower than those of local grocery stores. Indian standards of living across the social spectrum would rise immediately.

Licensing or quasi-licensing. In several sectors of the Indian economy—the dairy industry, to give one example—operators need a license from the government to compete. Although the licensing of dairy processors was supposed to ensure high levels of quality and hygiene, the licensing authority has in fact prevented high-quality private dairy plants from competing in certain areas, thus protecting government-owned plants and cooperative dairies from competition and from any incentive to shed excess labor or improve operations. Removing these restrictions would increase competition among processors, forcing them to make improvements by, for instance, using chilling centers and working with farmers to improve cattle breeds and milk yields (Exhibit 5).

Distortions in the land market

Close to 1.3 percent of lost growth a year, our calculations suggest, results from distortions in the land market—distortions that have so far largely been ignored in the public debate. These distortions limit the land available for housing and retailing, which are the largest domestic sectors outside agriculture. Less room to expand in these sectors means less competition among housing developers and retailers. Scarcity has helped make Indian land prices the highest among all Asian nations relative to average incomes (Exhibit 6). Three distortions in the land market are especially significant.

Unclear ownership. Title to most land parcels in India—90 percent by one estimate—is unclear, and the problem might take Indian courts a century to resolve at their current rate of progress. This lack of clarity about who owns what makes it immensely difficult to buy land for retail and housing development. Property developers and individual landowners also have trouble raising financing, since they can't offer as collateral for loans any land to which they don't have clear title. Not surprisingly, most new housing developments are constructed on land already owned by the developers or the few insiders who know how to speed up the bureaucratic title-clearing process.

Streamlining this process and revising the laws on land ownership would boost competition in construction. Competitive builders would improve their productivity and offer houses at lower prices. The sluggish Indian construction market would expand dramatically.

Counterproductive taxation. Low property taxes, ineffective tax collection, and subsidized user charges for power and water leave local governments unable to recover the cost of their investments in infrastructure, particularly in suburban areas. In Delhi, for example, water is supplied at only 10 percent of its true cost. Property taxes collected in Mumbai (formerly Bombay) amount to only 0.002 percent of the buildings' estimated capital value; the usual ratio in developed countries is 1 to 2 percent. With more efficient collection of higher taxes, local governments could invest in the infrastructure to support new housing developments on more and larger parcels of suburban land. Customers would have more choices, and developers would have to compete harder. Further, if developers could build up to 25 houses in a project instead of the single homes they more typically construct today, building costs would fall by up to 25 percent.

Conversely, stamp duties⁶ are extraordinarily high in India: close to 8 to 10 percent of the value of the property changing hands. Not surprisingly, this expense discourages the registration of land and real-estate transactions.

Inflexible zoning, rent, and tenancy laws. Land in city centers that would otherwise be available for new retail outlets and apartments is "frozen" by protected tenancies, rent controls, and zoning laws. Protected tenants cannot be evicted and will never voluntarily surrender their cheap tenancies, so their ancient buildings can never be sold or rebuilt. Tenancy laws also restrict competition: subsidized rents, for example, allow traditional inner-city counter stores to persist in their operational inefficiencies. But in Chennai (formerly Madras), the capital of India's southern state of Tamil Nadu, where rent control and zoning laws are less stringent, modern supermarkets already account for almost 20 percent of total food retailing compared with less than 1 per-cent in cities that have higher average incomes, such as Mumbai and Delhi.

Government ownership of businesses

Government-controlled entities still account for around 43 percent of India's capital stock and 15 percent of employment outside agriculture. Their labor- and capital-productivity levels are well below those of their private competitors (Exhibit 7), since public-sector managers experience little performance pressure. The near-monopoly status of government-owned companies in sectors such as oil, power, and telecommunications, for example, ensures that such companies will be profitable however unproductive they may be. Failing state-owned companies in industries open to competition, such as steel and retail banking, can get government support, so that they too manage to survive despite their inefficiency. In electric power and telecommunications, the government controls both the large players and the regulators, thus creating an uneven playing field for private competitors.

India's electricity sector illustrates how government control of companies can promote inefficiency. Government-owned state electricity boards lose a staggering 30 to 40 percent of their power, mostly to theft. By comparison, private power distributors lose only around 10 percent, mostly for technical reasons. Government subsidies, and corruption, give public-sector managers less motivation to control theft. Subsidies also limit their incentive to prevent blackouts and to maintain power lines—tasks that private companies undertake with better results. Privatizing the state electricity boards would save their government subsidies, amounting to almost 1.5 percent of GDP, and oblige managers to improve their financial and thus their operational performance. These managers would have to monitor theft and improve the capital and labor productivity of the facilities.

Dismantling the barriers

Thirteen policy changes would dismantle most of these critical barriers to higher productivity and growth (see sidebar, "How to make India's economy grow"). The changes include eliminating the practice of reserving products for small-scale manufacturers, rationalizing taxes and excise duties, establishing effective and procompetitive regulation as well as powerful independent regulators, reducing import duties, removing restrictions on foreign investment, reforming property and tenancy laws, and undertaking widespread privatization. If the government carried out these changes over the next two to three years, we believe that the economy would achieve most of the projected 10 percent yearly growth by 2005.

Such profound changes would certainly prompt resistance in the name of social objectives, especially from those protected by the current regulatory regime. But the fact is that the current policies have not achieved their social purposes, however worthy: many have been counterproductive. Reserving products for small companies, for example, has cost India manufacturing jobs by preventing companies from becoming productive enough to compete in export markets. Similarly, tenancy laws designed to protect tenants have driven up nonprotected rents and real-estate prices, thus making ordinary decent housing unaffordable to many Indians.

Critics might still argue that the increase in GDP resulting from these policy changes will all flow to the already rich. But after carefully examining the expected effects of the proposed reforms on the Indian economy, we can see that, once again, the opposite is true. By creating a virtuous cycle of broad-based growth in GDP, the changes will benefit every Indian. For example, the real incomes of farming families—the poorest group—will rise by at least 40 percent over ten years.

The effects of reform

India's economy has three types of sectors. Modern ones, with production processes resembling those in modern economies, provide 24 percent of employment and 47 percent of output. Transitional sectors provide 16 percent of employment and 27 percent of output. Agricultural sectors provide 60 percent of employment and 26 percent of output. The transitional sectors include those responsible for the informal goods and services consumed by a growing urban population: street vending, domestic service, small-scale food processing, and cheap mud housing, for example. Transitional businesses typically require elementary skills and very little capital and therefore tend to absorb workers moving out of agriculture.

What will happen to the economy if India immediately dismantles all existing barriers to higher productivity? Our analysis shows that the resulting increase in labor and capital productivity will boost growth in the overall GDP to 10 percent a year, release investment capital worth 5.7 percent of GDP, and generate 75 million new jobs outside agriculture, in both the modern and the transitional sectors.

Labor productivity

Eliminating all the productivity barriers would almost double India's rate of growth in labor productivity, to 8 percent a year, over the next ten years. The modern sectors would account for around 90 percent of the growth (Exhibit 8), which would remain low in the other two sectors. There may be small improvements in agricultural productivity, mainly from yield increases. But the massive improvement in agricultural productivity that mechanized farming has supported in developed countries isn't likely to occur in India for at least ten years while there is still a surplus of low-cost rural labor to deter farmers from investing in advanced machines. In the transitional sectors, enterprises have inherently low labor productivity because they use labor-intensive low-tech materials, technologies, or business formats. So although these sectors will grow to meet rising demand, their labor productivity will stay about the same.

Capital productivity

If all the barriers were removed, capital productivity in the modern sectors would grow by at least 50 percent over the next three to four years. Increased competition would force managers to eliminate the tremendous time and cost overruns of capital projects and the low utilization of installed capacity—problems that managers can get away with now, especially in state-run enterprises. If equitably enforced, regulation to ensure healthy competition would prevent the unwise investments that are common today, such as the construction of subscale and underutilized steel mills.

Investment

Many policy makers and commentators believe that it would take a level of investment equal to more than 35 percent of India's GDP—an almost unattainable amount—to make the country's GDP grow by 10 percent a year. But our analyses suggest that by eliminating barriers to higher productivity, India can achieve this rate of GDP growth with a level of investment equivalent to only 30 percent of GDP a year for a decade, less than China invested from 1988 to 1998. Although still a challenge, this 30 percent rate is certainly achievable, since removing the barriers to productivity will unleash for investment extra funds equivalent to the consequent drop in the public deficit and encourage greater foreign direct investment. These sources, by themselves, would be sufficient to increase investment to 30.2 percent of GDP, from its current level of 24.5 percent.

How would the funds be released? Removing the barriers to higher productivity would, first, generate extra revenue for the government through more efficient taxation—particularly on property—and from privatization. Second, reform would save what the government now spends on subsidies for unprofitable state-owned enterprises. As a result, the government's budget deficit would decrease by at least 4 percent of GDP, which would then become available for private investment elsewhere.

Current flows of foreign direct investment into India are worth just 0.5 percent of GDP. Many developing countries, including China, Malaysia, Poland, and Thailand, consistently attract foreign direct investment worth more than 3 percent of their annual GDP. We estimate that removing the three major barriers by opening all modern sectors of India's economy to well-regulated competition and lifting restrictions on foreign direct investment will increase it by at least 1.7 percent of GDP within three years.

Employment

Productivity growth and increased investment will create more than 75 million new jobs outside agriculture, compared with the 24 million projected as a result of current policies. Employment in the modern sectors will increase by around 32 million jobs as higher productivity and lower prices stimulate demand. Similarly, employment in India's transitional sectors will grow by around 43 million jobs. The transitional sectors—often overlooked by policy makers—will play a crucial role in India's evolution from an agricultural to a more modern economy, since it is these sectors that will initially absorb workers moving out of agriculture. Agricultural wages will therefore rise.

This migration of labor among sectors is a feature of all strongly growing economies, for though higher productivity displaces labor in some sectors, it stimulates higher overall employment. But what of the workers laid off by overstaffed companies in newly productive modern sectors? Most of these people will be able to find work in efficient companies in their own or other growing sectors. Many overstaffed companies, such as small steel plants, state electricity boards, and branches of government-owned banks, are located near towns or cities, where most of the new jobs are likely to emerge. Redundant workers close to retirement age will be able to take up early retirement packages, which in India are generally worth three to four years' salary.

India will be a very different country in ten years, with a GDP of around $1.1 trillion, if these reforms are undertaken. Average individual Indians will be more than twice as rich and will probably live in the world's fastest-growing economy. Best of all, this is no pipe dream but an achievable goal—if the government and the people of India act decisively and soon.