India's Local Governance: Key to Economic Growth

India's local government capacity and incentives hindered its ability to replicate China's growth miracle, despite improvements and potential for unique growth.

### Why India Can Never Grow Like China, But Still Has Hope for Its Own Unique Growth Miracle
* 📉 India's economy started at roughly the same size as China's in the 1980s, but China soon surpassed India, becoming **roughly five times its size**.
* 🇨🇳 China's growth path, characterized by **investment-led growth**, **liberalization**, and attracting **foreign direct investment (FDI)**, was not replicable by India due to its **unique political structure**.
* 📚 According to Professor Raghuram Rajan, China's initial advantage over India was its **better level of basic education**, which facilitated the **attraction of foreign factories** and the subsequent growth of **local entrepreneurs**.
* 💰 China directed credit from state-owned banks to **infrastructure and manufacturing**, while India's state-owned banks lent to **well-connected tycoons who did not invest productively**.
* 🏭 China attracted FDI to **acquire knowledge from efficient factories** and **obtain foreign currency for crucial imports**, while India struggled to attract a **similar amount of FDI**.
* 🏛 Professor Davesh Kapur identified three key reasons why India's local governments are not able to promote growth like their Chinese counterparts: being **understaffed**, the influence of the **caste system**, and being a "**precocious democracy**".
* 🇮🇳 Despite these challenges, India has made progress in education and infrastructure, and its potential to **attract FDI as an alternative to China** is promising.
* 🌐 While a China-style growth miracle is unlikely, there is optimism that India, with **improved local government capabilities** and potential for reforms under a **more democratic coalition government**, can achieve its own unique, **slower, but ultimately successful growth miracle**.

This graph shows that while in the 1980s,
China's and India's economies started at roughly the same size. China soon left India in the dust,
becoming roughly five times its size. However, now, with China's economy
slowing down and Western companies
seeking to move their factories elsewhere, could it be that it is now India's
turn to replicate China's growth miracle? That is the question
that has been keeping up both India and the world lately. However, to avoid cliche answers
like it needs to reduce corruption, liberalize its economy even more,
or increase education and infrastructure. In this video, I've turned to
two of India's most eminent economists: its central bank president,
Professor Raghuram Rajan, and Johns Hopkins Professor Davesh Kapur, and summarized
their vast bodies of research into key insights
about exactly one why China's economy took off after the liberal reforms
of the 80s and 90s.

While India did not, why China's growth path will never work for India. And finally, whether or not India will soon be able to pull off its own growth miracle. And I'm happy to report that in their research, I found some really surprising insights about how India's real problem is not that it didn't know what to do, but rather that it failed to properly implement China's strategy due to its own unique political structure, in which understaffed local governments often cater to local interests rather than to the public. A structure that means that while there are other growth models for India to follow, the country could not and still can never grow like China. But to see why that is the case, we first need to answer why China outgrew India in the first place. In other words, what caused this massive divergence between India and China in the 1990s and early 2000s? To answer that question, I first turned to the work of Professor Raghuram

Rajan, who has highlighted that already in the late 1970s, Chinese workers had a better level of basic education than their Indian counterparts, a better level of basic education enables two key elements of how China transitioned from an agricultural society to the manufacturing powerhouse that it is today. The first element is that to supercharge economic growth, China started attracting a lot of foreign factories in the 80s and 90s, factories that typically required at least a basic education from their workers so that they could follow simple instructions. The second element is that a basic education, especially in accounting, enabled a lot of these workers to then later start their own companies, which propelled China's economy to the next level in the 2000s. But given that there were plenty of countries with a better level of basic education in China in the late 1970s, better education alone cannot explain why China was able to attract

foreign factories and enable its workers
to start their own factories. Well, India was not. Indeed, as I discussed in my video
about China's economic miracle. Besides being able to attract foreign factories to learn from them,
there are two other key ingredients that allowed China
to transform its economy into the manufacturing superpower
that it is today. The first and most often discussed
ingredient is that in the 1980s, communist China liberalized its economy
both by allowing private entrepreneurs to start companies and by allowing
foreign firms to come into China. In my opinion,
this was indeed a necessary condition for the Chinese economic
miracle to happen. But given that there are plenty of more,
liberalized economies cannot explain China's
rapid growth by itself. India is a prime example of that. Following China, India also carefully liberalized
its socialist economy in the 1990s, and this was then followed by more
radical liberalization in the 2000.

But while India's economy certainly
grew faster after these reforms, it never quite reached China's
double-digit growth numbers. Of course, you could then argue that India just didn't
liberalize enough, and that may be true, but China is also still
a highly restrictive place to do business today, scoring very similar points
to India when we compare the two countries, for example,
using the Index of Economic Freedom. Therefore, to explain this massive
divergence between the two countries, I believe that we need to talk
about the second and third ingredient of the Chinese growth
miracle ingredients that India was never able to reproduce
despite the best intentions. Okay, the second key
ingredient of the Chinese growth miracle is that it followed
what Peking University professor Michael Pettis calls the investment-
led growth model. This is the growth model that was at
the heart of miracle growth in countries like the United States, Germany, and Japan,
and then was later adopted by China.

Essentially, the idea of investment-led growth is that in poor countries like China and India in the 1980s, they have a huge underinvestment problem while they have a population that could potentially be very productive. They are held back by a lack of infrastructure, knowledge, and productive assets such as machinery. So to grow at a miracle level speed, a poor country simply needs to invest at miracle level speed in infrastructure and other productive assets. But where does that money come from? You know, in a poor country, perhaps surprisingly for a non-economist, a lack of money in even the poorest countries is never the real problem. After all, in a fiat money system, local money is infinitely available since a central bank can just print as much as it likes and use that money to spur unemployed workers into action. However, because the central government of these massive countries alone cannot really hope to spend all of that money productively to prevent inflation, they have essentially outsourced most money creation to commercial banks.

who create money as debt, that money
that will not produce inflation and will not increase debt to GDP,
as long as it is used to grow the economy. So, to make sure that China's banks
invest in productive infrastructure and factories, China ordered its local
and state-owned banks to direct credit, mostly to infrastructure
and manufacturing. Other low-interest rates. And while these state interventions
can now explain why China has too much infrastructure
and even too much factory capacity, it worked extremely well when China
was still a developing country. But what about India? Why didn't India try
to follow the investment-led growth model and supercharge investments
in factories and infrastructure? Well, actually it did well. It liberalized its corporate sector. It kept its banking system largely
in the hands of the state, just like China and just like China. That banking system then went on a lending spree
to well-connected business tycoons. However, unlike China's
successful entrepreneurs,

India's well-connected tycoons
did not spend the money productively, which meant that around 2013,
while China's corporates increasingly conquered the world,
India's corporates were failing and heavily indebted to a state's
banking system that was close to collapse. Although I have to say that since then,
India's investment has gotten much better. A recovery that was partially made
possible by Professor Rajan himself, who as head of India's central bank,
helped clean up a lot of these bad debts. A lot of credit also goes to Modi,
who has since coming to power in 2014, made a lot of new investments
in India's infrastructure. But while Indian investment
and growth has not been bad at all, it has not been as miraculous
as that of China. Therefore, I think it's now time
that we revisit the third key ingredient of China's growth
miracle attracting foreign factories, which is also known as attracting foreign
direct investment or FDI for short.

FDI gets its name from the fact that if you build a factory somewhere,
you are directly investing there. When it comes to FDI, while China became
the factory of the world, India simply failed to attract anywhere
close to the same amount of FDI. But why is it attracting FDI so important, and why was China able to do it
while India failed miserably? To answer these questions, let's
go back to India and China in the 1980s. They were not just like infrastructure
and machines. They were also lacking the knowledge
about how efficient factories operate. Knowledge that you cannot learn in school. Knowledge that you instead accumulate
by working in efficient factories. This is why attracting foreign factories
to turbocharge local knowledge was the third key
ingredient for China's growth. Miracle. On top of that,
while local money is in theory infinite as it can be created by local banks
and central banks, foreign money U.S.

dollars is needed for crucial imports,
such as, in China's case, German machines. So attracting foreign direct
investment is a key ingredient of most growth miracles, because it can be
used to supercharge local knowledge and to obtain the US
dollars needed for crucial imports. And as we've discussed,
China's basic education really helped
create the right environment for FDI. But according to Professor Rajan,
there's actually a deeper difference between China and India, and that is how
well their local governments function. You see, because both the Chinese
and Indian economies are decentralized systems on a massive
and I mean massive scale. It's really important to note
that getting education, investment, and FDI right is really not something
that is determined at the top. You need government at the local level
to actually implement these changes, and for that,
they need the right incentives. And if we zoom in to how China's
local governments work, we can see that
they had the right incentives to stimulate

both local investment
and foreign direct investment. First of all, local governments were
all part of the Chinese Communist Party, and they would be promoted or demoted,
not based on how well like they were by the local population,
or how loyal they were to the boss, but rather by how much they were able
to grow their local economy. On top of that,
a large part of local government revenue was to be generated through land sales. And given that the value of land appreciates
when the right infrastructure is built. If local governors wanted to further
their career in the party, one of their best options
was to build infrastructure such that they could get more revenue and increase
the GDP of their province or city. And okay, maybe also skim
a little bit off the top in the process. Importantly, these incentives
meant that local Chinese governors were really keen to make things
as easy as possible for foreigners that wanted to invest in their city. For example,
as Professor Rajan describes in this book,

when an Indian businessman wanted to invest in a middle-sized city in China, he was met at the airport by the deputy mayor, taken to visit a possible site on the same day, and then immediately taken to the mayor's office, where all the necessary paperwork had already been filled out and any problems he raised could be dealt with by the local government. Similarly, when Elon Musk came to China, he was able to have his Shanghai factory up and running in record time because the local Shanghai government officials cleared all legal obstacles for him. Contrast this to India, where while the central government assured citizens that it was now a great destination for FDI, its local government often actively frustrated the arrival of foreign firms by strictly upholding India's difficult regulations and making it time-consuming to get around them. In summary, following the insights from Professor Rajan, China was able to outgrow India initially because it had a better level of education.

And while both countries liberalized
their economies, only China was able to successfully invest on a colossal scale
and attract enough foreign direct investment
to supercharge its economic growth. Finally, it's not that India's
central government was not aware that it needed
to invest more and attract FDI. No, the deeper reason
why India was not able to keep up with China is that its local governments
did not play along. Whereas in China,
local governors had the right incentives to promote both local investment and FDI. And sadly, if we next turn
to the work of Professor Davesh Kapur, I'm afraid it will become clear
that not only did dysfunctional local governments hold India
back in the past, they also mean that even today, India can never grow
like China. Okay. To understand
why India's local governments are failing to unleash a China-style miracle,
let's now turn to Professor Kapoor, who has identified
the three most plausible explanations.

The first explanation is really straightforward. India's local governments are terribly understaffed, especially when compared to China, which greatly increased its local government capacity during its growth. Miracle. Indeed, if we look at this graph, we can see that the structure of India's government employee count is basically the opposite of that of China and the United States. Whereas in the US and China, by far most government employees work at the local level and only some at the state or federal level. In India it is the other way around. Most of India's government employees work at the state and to a lesser extent, federal level, whereas only a few work at local level. This can explain why India's local governments were not able to invest or help foreign investors around the rules on the same scale as their Chinese counterparts did. But if just local capacity was the only problem, then it could simply be solved by giving the local governments more money to hire more people, right?

Well, sadly, that will likely
not completely fix the problem. You see,
there is something really strange going on with India's local governments,
despite high unemployment. Many local governments
have thousands of unfilled open positions. Even worse,
some of India's poorest local governments do not even spend all the money
that they get from the central government. So what else is going on? Well, this brings us to Kapur's
second explanation of why in this, local governments
are not living up to their potential. India's infamous caste system,
which divides people into a hierarchy of social categories,
based on their birth. But before getting into how we should note that the caste system
has effectively been outlawed. However,
despite that, in many parts of the country it is still very much a political reality. The caste system can explain India's dysfunctional local governments
in three different ways. Firstly, realizing that the caste system
was still strong at the local government

level. India's founders, on purpose,
made sure that local governments were not too powerful, which can explain
why this graph looks the way that it does. Secondly, even if a local government
has adequate capacity, they might not have the right incentives,
meaning that they may frustrate the implementation
of well-meant central government policies because it is not in line
with a caste system. As an example, Professor Kapoor mentions
that quite a few federal education programs, where schools were built
to improve the education of girls, failed at the local level
because, and I'm quoting, what happens within
the classroom is affected by caste and gender norms. Thirdly, in some extreme cases,
the caste system even leads to government vacancies
potentially being left open because they only have candidates
from higher costs. For example, in their book The Narrow Order, Professor Acemoglu and Robinson describe
how in one of India's poorer states, Bihar, the state had thousands of vacancies
for engineers that were not filled.

despite high unemployment. Why not? Well, because those qualified to be
engineers are typically from higher costs. But because the province's reigning
governor, Lalu Prasad Yadav, was from a lower caste,
he refused to fill these positions. Of course, as a consequence, everyone suffered because the government of the here
was so severely understaffed that it could not even spend all the money
it got allocated from the central government
to upgrade the local infrastructure. But okay, that is an extreme case
which may not be applicable to all states, but it is applicable to
all of any of though is the third reason why its local governments
are not enabling businesses like their Chinese counterparts,
and that is that India is a democracy. Now, I want to stress that in itself,
this is not a problem at all. Sure, in China,
the incentives of a promotion in the party meant that local governments
could override local concerns to build infrastructure and go out
of their way to attract foreign firms.

However, in well-functioning democracies,
this does not need to be a problem, since the democratic process itself
could give local governors the incentive to invest in their cities
and to attract foreign firms. After all, if you as a local governor
grow your economy, you know, then you're more likely
to be reelected as local governor again. Indeed, democracy has produced the vast
majority of growth miracles, ranging from West Germany to Italy to Japan
and to the United States. However, unlike these countries, Professor
Kapur claims that India is a so-called precocious democracy,
meaning that a country became democratic before it was
perhaps ready to become democratic again. Professor Kapur discusses three reasons why this is holding
India's local governments back. The first is that a precocious
democracy can get into a vicious cycle in which it delivers poor public services
like schools and health care at a time. But it is established as a consequence.

Wealthier people will exit the public system and start using private schools and hospitals instead. And therefore they are now less willing to pay taxes, making local government services even more dysfunctional. Indeed, as Professor Kapur notes, local governments in India in particular seem to be very hesitant to raise their taxes, the taxes that they need to improve their cities. But sadly, there's more. The second reason why being a precocious democracy is holding India back is that because India's so divided local government officials that were elected by their specific caste or religious group or, you know, any other interest group tend to prefer rewarding their voters by giving them subsidies or other specific benefits, rather than to invest in public services that can be enjoyed by all. Finally, in precocious democracies, politicians will tend to emphasize public goods that are highly visible and relatively easy to provide. For example, they may prefer to invest in hyper modern metros.

rather than to invest
in improving the education system, of which the results
will only be seen after a few years. Of course, this, you know,
happens in any democracy, but more so in precocious democracies.
This is what Professor Kapoor argues. So on the surface, India did not grow as fast as China
because it lacked basic education. They didn't invest as much and didn't
attract as much FDI. But the deeper reason
is that India's local government did not have the capacity,
nor the right incentives to improve education, invest a lot and to attract FDI due to a lack of personnel
and wrong incentives provided by the caste system and India
being a precocious democracy necessarily. Despite a lot of good intentions
by the Modi government, all of these causes of India's local
government dysfunction are still in place and this is why I am confident to say
that India can never grow like China, especially now that Modi,
who became increasingly autocratic.

in recent years,
lost his majority in parliament. So, does that mean that there is no hope
for India to ever catch up to China? No. I'm actually quite optimistic because there are still a few reasons
to be optimistic about India's economy. First of all, if we compare
India to the place it was in the 1980s, we will see that well may not have gone
through miracle growth. People are now better educated,
and its infrastructure has received a major upgrade, especially on the digital
and financial side. And given that foreign companies
are increasingly looking for an alternative
to China, India is, in theory, really well positioned to attract
a lot of foreign direct investment. Now, of course, FDI in India has not yet
been anything to write home about due to the fact that the local governments
do not have the capacity or incentives to help foreign firms
navigate its complicated rules. However, now that India has elected
a more democratic coalition government,

some have argued that this could mean
that Modi now has to work more closely together with local governments
to push through reforms. Closer cooperation in a divided nation
will never put in there on the path of China, but it could put it
on the path to the United States. A big, divided nation
that went through a slow, messy. But what, in the end turned out to be the most successful
growth miracle of all time. Finally, perhaps more importantly,
as Professor Kapur notes, a successful implementation
of various programs such as opening bank accounts, gas connections, and toilets
that connect to the sewage system. This demonstrates that slowly but surely, local government
capabilities are improving. But yeah, I don't expect a China-style
miracle anytime soon, but I am still optimistic about India's
potential to grow in the upcoming decades. But yeah, that is my take. Do you agree with me
that India can never grow like China?

but that it is now actually well positioned for its own unique, messy, slower, but perhaps ultimately more successful growth miracle? Let me know in the comments below. Finally, given that primary education is often a local government responsibility, and that this capacity has recently increased, this could mean that this is where improvement will be felt. And next, which could be huge, because having a broadly shared basic level of education will give more Indians access to an unprecedented wealth of online materials, such as the unique lessons provided by today's video sponsor. Brilliant. Brilliant’s thousands of lessons in math, data analysis, programming, and A.I. are unique because I focus on learning by doing rather than learning through reading a book or by watching a video lecture. Each of their lessons, crafted by high-profile educators from the likes of MIT, Caltech, Google, and more, is filled with hands-on interactive exercises, which is a method that has been proven

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Economist explains why India can never grow like China

Money & Macro

The Divergence of China and India's Economies

China's economy quickly outgrew India's in the 1980s and 90s, due to better basic education for workers, the ability to attract foreign factories, and the liberalization of its economy.

India's slower growth was a result of its failure to replicate China's strategies, despite its own economic liberalization.

The investment-led growth model and the ability to attract foreign investment were key factors in China's economic miracle, which India was unable to reproduce.

The Role of Investment-Led Growth in China and India

Poor countries like China and India experienced a lack of infrastructure and productive assets, hindering their growth potential in the 1980s.

China successfully implemented investment-led growth by directing credit to infrastructure and manufacturing, leading to a rapid economic expansion.

In contrast, India struggled to attract foreign direct investment and effectively utilize its corporate sector for productive spending, resulting in less miraculous growth compared to China.

The Impact of Local Governments on Foreign Investment in China and India

China's success in attracting foreign direct investment (FDI) and stimulating economic growth is attributed to the effective functioning and incentives of its local governments, which prioritized and facilitated FDI, in contrast to the obstacles faced by foreign firms in India.

The local government in China provided a supportive environment for FDI, offering streamlined processes, while in India, local governments struggled to cooperate, leading to a lack of FDI and hindering economic growth.

The difference in the effectiveness of local governments in promoting FDI ultimately contributed to China's ability to outpace India's economic growth.

India's local governments are severely understaffed, with the majority of employees working at the state or federal level, unlike the US and China.

Many of these local governments have thousands of unfilled positions, even in the face of high unemployment, and some struggle to spend the money allocated to them.

The country's infamous caste system also plays a significant role in the dysfunction of local governments, impacting their power, incentives, and the filling of government vacancies.

Additionally, India's status as a democracy presents challenges in comparison to the authoritarian approach of China in attracting foreign investment and building infrastructure.

The Impact of India's Precocious Democracy

India's early adoption of democracy has led to a vicious cycle of poor public services, a divided government, and a focus on visible projects over long-term investments.

These factors have hindered the country's growth and its ability to compete with China.

However, despite these challenges, there is optimism for India's economy due to improvements in education, infrastructure, and its potential to attract foreign investment as an alternative to China.

Modi may need to collaborate with local governments to implement reforms, potentially leading to a growth path different from China's.

The improvement in local government capabilities could have a significant impact on primary education and access to online learning materials for Indians.

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