In India, diverging incomes despite equalising forces

Tue 21 Feb 2017

If India has to do well, the States as a whole must do well — which also requires that large differences in economic development between them must narrow over time. Economists call this narrowing — reduction in relative disparities — “convergence”.

This year’s Economic Survey throws up a deep puzzle about convergence within India. Rather, one striking outcome suggests two puzzles. The outcome is this: in the 2000s, while standards of living (measured in terms of Gross State Domestic Product or consumption) per capita increased in all the States, the disparities among them also increased. In other words, there was divergence across the States instead of convergence. The first puzzle stems from the international comparisons: across countries disparities are declining in contrast to India. The second puzzle is a temporal one: the tendency towards disparities within India has been strengthening, not weakening, over time.

Bucking a global trend

Figure 1 shows the general improvement in living standards across the States. It plots the level of real per capita GSDP over time between 1984 and 2014. There has been an across-the-board improvement reflected in the whole per capita GSDP distribution shifting right, e.g. between 1984 and 2014, the least developed State (Tripura) increased its per capita GSDP 5.6 fold (from per capita GSDP of Rs. 11,537 in 1984 to Rs. 64,712 in 2014) and the median State (Himachal Pradesh) increased its income level 4.3 fold.

Next we document divergence. Convergence occurs when a State that starts off with a lower level of per capita GDP sees faster growth of per capita GDP in the future so that it catches up with better-performing States. If we plot per capita GDP growth on the y-axis and the initial level of per capita GDP growth, convergence would show up in the form of States being distributed around a downward sloping line.

This is what we do on Figure 3, which plots this relationship for the period 2004-2014 for the Indian States (blue), Chinese provinces (red), and countries in the world (green). The line for India is upward sloping while those for the Chinese provinces and countries in the world are downward sloping.

Poorer countries are catching up with richer countries, the poorer Chinese provinces are catching up with the richer ones, but in India the less developed States are not catching up; instead they are, on average, falling behind the richer States. Internationally, growth rates of per capita GDP widened at least since the 1820s with poorer countries growing slower than richer countries, leading to the basic divide between advanced and developing countries characterised as “Divergence, Big Time” by Prof. Lant Pritchett of Harvard University. However, since 1980 this long-term trend was reversed and poorer countries started catching up with richer ones. In stark contrast, there continues to be divergence within India or an aggravation of regional inequality.

What is especially striking is how convergence has evolved over time. In the 1990s, convergence patterns were not dissimilar (Figure 2) across the world, China and India with either weak convergence or divergence. But things really changed for both the world and China in the 2000s; however they did not change for India. This was despite the promise that less developed States such as Bihar, Madhya Pradesh and Chhattisgarh had started improving their relative performance. But the data show that those developments were neither strong nor durable enough to change the underlying picture of divergence or growing inequality. The findings are similar when we use consumption per capita instead of GSDP per capita.

Therefore, the evidence so far suggests that in India, catch-up remains elusive. The opposing results in India versus those in China and internationally pose a deep puzzle. Convergence happens essentially through trade and through mobility of factors of production. If a State/country is poor, the returns to capital must be high and should be able to attract capital and labour, thereby raising its productivity and enabling catch-up with richer States/countries. Trade, based on comparative advantage, is really a surrogate for the movement of underlying factors of production as economist Paul Samuelson pointed out early on. A less developed country that has abundant labour and scarce capital will export labour-intensive goods (a surrogate for exporting unskilled labour) and import capital-intensive goods (a surrogate for attracting capital).

The findings suggest that India stands out as an exception. Within India, where borders are porous, convergence has failed whereas across countries where borders are much thicker (because of restrictions on trade, capital and labour) there is a convergence dynamic. That is not easy to explain. That is the cross-country puzzle.

The Indian puzzle is deeper still as contrary to perception, the Economic Survey shows that trade within India is quite high and mobility of people has surged dramatically — almost doubled in the 2000s. These indicate that India has porous borders — reflected in actual flows of goods and people — and that porosity has been increasing. Yet over time, divergence has been increasing rather than narrowing. That is the inter-temporal puzzle within India. The driving force behind the Chinese convergence dynamic has been the migration of people from farms in the interior to factories on the coast, raising productivity and wages in the poorer regions faster than in richer regions. But India is not lagging far behind and yet disparities have been widening.

A governance deficit?

Although further research is required to understand the underlying reasons, one possible hypothesis is that convergence fails to occur due to governance or institutional traps. If that is the case, capital will not flow to regions of high productivity because this high productivity may be more notional than real. Poor governance could make the risk-adjusted returns on capital low even in capital-scarce States. Moreover, greater labour mobility or exodus from these areas, especially of the higher skilled, could worsen governance.

A second hypothesis relates to India’s pattern of development. India, unlike most growth successes in Asia, has relied on growth of skill-intensive sectors rather than low-skill ones (reflected not just in the dominance of services over manufacturing but also in the patterns of specialisation within manufacturing). Thus, if the binding constraint on growth is the availability of skills, there is no reason why labour productivity would necessarily be high in capital-scarce States. Unless the less developed regions are able to generate skills (in addition to providing good governance), convergence may not occur.

Both these hypotheses are ultimately not satisfying because they only raise an even deeper political economy puzzle. Given the dynamic of competition between States where successful States serve both as models (examples that become evident widely) and magnets (attracting capital, talent, and people), why isn’t there pressure on the less developed States to reform their governance in ways that would be competitively attractive?

In other words, persistent divergence amongst the States runs up against the dynamic of competitive federalism which impels, or at least should impel, convergence. The move towards economic divergence across India in the face of the equalising forces of trade and migration is a deep puzzle waiting to be unravelled.

G. Gayathri, Navneeraj Sharma and Chief Economic Adviser Arvind Subramanian worked on this year’s Economic Survey. G. Gayathri, Navneeraj Sharma are consultants to the office of the CEA.


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