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The Economic Times

View: India has a labour productivity problem and it stands in the way of economic growth

labour-reforms-bccl
GST and the bankruptcy law are a very good start. But India needs another booster-dose of productivity-enhancing reforms.
By Sajjid Z Chinoy

The debate on whether India’s slowdown is cyclical or structural is moot. Both sets of forces are currently at play and, therefore, the policy response needs to be all-encompassing. For starters, there’s undeniably a cyclical element at play. Growth has slowed from 8% to below 6% in four quarters, and it cannot be anyone’s contention that potential growth has fallen by this quantum in a year.

If potential had fallen with actual, the momentum of core inflation wouldn’t have collapsed from 6% to 3% as it has. The latter clearly suggests output gaps have opened up. The challenge, therefore, is not in recognising some part of the slowdown is cyclical, but deciding how to respond.

The clamour for a fiscal stimulus has renewed. But given that the public sector is already consuming all household financial savings, any fiscal relaxation would be dangerously counterproductive, by pushing up interest rates and further impeding monetary transmission. In just the last week, bond yields have hardened 20 basis points (bps) on fiscal relaxation fears, thereby undoing all the softening after RBI’s 35 bps rate cut. Policymakers must, therefore, exhibit strategic fiscal restraint.

Instead, the near-term policy focus must be to improve monetary transmission — resolving asymmetric information in the non-banking financial companies (NBFC) sector, goading banks and small savings to link rates to external benchmarks — keeping the exchange rate externally competitive, and boosting sentiment by aggressively front-loading privatisation and asset sales.

The real challenge, though, awaits in the medium term. ‘Structural slowdown’ fears have only gained currency because India’s much-vaunted consumption story suddenly looks vulnerable — an unprecedented phenomenon in recent memory. Here, too, there are cyclical and idiosyncratic factors at play: worsening agrarian terms of trade have hurt rural purchasing power, and the auto sector is facing a perfect storm of cyclical and regulatory pressures.

Not in Save Haven
But cyclical pressures apart, there are structural undertones to the slowdown. In recent years, household consumption has been financed by sharply running down savings, which have fallen from 23% to 17% in six years.

In other words, income/wage growth has been running much below consumption growth, forcing households to run down their savings and/or take on debt to finance consumption. This is unsustainable beyond a point. If wages and incomes don’t accelerate, consumption will be forced to slow down.

The wage-consumption disconnect is best seen in the rural economy. Over the last five years, real rural wages have grown at an average annual rate of just 0.9%, while consumer non-durables (a proxy for rural consumption) have grown at an average of 6.5%. At some stage, consumption had to asymptote down towards wage growth. So, why aren’t wages, more generally, picking up? In a relatively competitive market, wages ultimately reflect labour productivity.

Therein lies the nub of the issue: unless labour productivity picks up, wages and incomes cannot support strong consumption growth. Telltale signs of productivity challenges are also visible in other places.

India’s non-oil, non-gold trade deficit has meaningfully worsened in recent years. To be sure, exchange rate dynamics haven’t helped, with the rupee appreciating almost 15% in real terms over the last five years. But the fact that India’s trade deficit with China has widened by a factor of 10 in 15 years, across exchange rate regimes, it suggests a more fundamental productivity/competitiveness challenge at play.

Similarly, despite India’s high labour endowment, organised manufacturing has become progressively more capital-intensive, with labour intensity falling by a factor of five since 1980.

Why? Partly because technological advances have boosted the marginal product of capital, while labour productivity hasn’t grown in tandem. Voting with their feet, entrepreneurs have revealed that, after adjusting for productivity, labour is not an attractive factor of production.

One important byproduct of the goods and services tax (GST) is to boost the formal economy and facilitate employment into organised manufacturing. Ironically, however, larger firms are typically more capital-intensive. Therefore, until labour productivity is boosted — so that labour becomes a more attractive factor of production — both employment and wages will remain under pressure.

Is the labour productivity challenge cyclical or structural? Investment has stagnated for a decade, and, in theory, this hurts labour productivity because labour is endowed with less capital. If investment were to pick up, labour productivity should be expected to lift. But GDP data suggest investment growth accelerated to 10% over the last two years, despite which wages don’t appear to have picked up.

Instead, both ‘labour quality’ (education and skilling) and ‘total factor productivity’ (technology/reforms/infrastructure) also appear to be binding constraints.

What should policymakers do? The prescriptions shouldn’t come as a surprise. First, create growth opportunities outside agriculture so that people can migrate to higher-productivity jobs outside agriculture.

Second, encourage growth of firmsize. Larger firms are typically more productive than smaller firms (reflected in higher wages paid by larger firms). Frictions that prevent firms from growing (rigid retrenchment laws) must be liberalised, and incentives shouldn’t be a function of firm size.

The recent corporate tax cut was welcome. But by limiting it to firms below Rs 400 crore revenue, it disincentivises firms from growing. While larger firms are more productive, they are also typically more capital-intensive, though. So, policy needs to incentivise both firm growth and labour intensity.

Skilled on the Job
Third, broaden the menu of job contracts. Most skilling happens on the job. But rigid labour laws induce firms to hire ‘one-year’ contract labour, which disincentivises firms from investing in skilling. Therefore, a richer menu of longer contracts is necessary.

Fourth, urgently reform education and health as the surest way to boost human capital and productivity.

GST and the bankruptcy law are a very good start. But India needs another booster-dose of productivity-enhancing reforms. Without boosting labour productivity (and, therefore, jobs and wages), India will neither be able to sustain its fabled consumption story at home, nor be able compete globally. This must be the overriding takeaway from the current slowdown.

(The writer is chief India economist, JPMorgan)
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