Will a harsher world accelerate India’s reforms?

“WHEN WE grow and excel,” Narendra Modi said in a speech on August 15th to mark the 78th anniversary of India’s independence, “the world will acknowledge our worth.” It was the Indian prime minister’s first major public address since Donald Trump decided to punish the country for its use of Russian oil by doubling tariffs on various goods. He struck a defiant tone, insisting that India would take its seat at the top table by becoming stronger at home. “We have resolved to accelerate the journey of reform,” he added.

Mr Modi, an economic reformer, wants India’s GDP to reach $10trn by the centenary of its independence, in 2047 (currently it is $4trn). That would give it “developed-country status”, and give it even more global heft. But meeting that goal means sustaining India’s current growth rate for more than two decades—at a time when the world economy is slowing and countries are erecting trade barriers.

India has unique strengths: a vast pool of cheap labour, masses of untapped talent and a huge internal market. Yet its problems are enormous, too. Its companies are still held back by restrictive laws. Its rural people are chronically underemployed. Its cities are ill-prepared for mass urbanisation. Having lost his majority in national elections held last year, Mr Modi’s appetite for tough reform had seemed diminished; even his supporters had begun to suggest that states would have to take the lead. The question now is whether an external shock will be a catalyst for change.

It would not be the first time. In recent weeks there has been chatter about “another 1991 moment”. That was the year when a balance-of-payments crisis triggered a wave of liberalisation, in which capital controls were lifted, and the dismantling of the “licence raj” began. In part, the comparison reveals how far India has already come. In 1991 the country was left on the verge of bankruptcy; with no money to buy oil, its economy ground to a halt. Almost half the population was living in extreme poverty; today it is less than one in 20. And India will soon be the world’s fourth-largest economy.

Mr Modi has contributed to India’s successes in three areas. The first is economic stewardship. In his first term he reformed the banking system, forcing banks to clean up their balance sheets. On his watch the government has controlled spending, and the Reserve Bank of India (RBI) has held inflation and interest rates down. India’s balance-of-payments is now much less fragile. The day before Mr Modi’s speech, S&P, a credit-rating agency, rewarded India with its first sovereign-credit rating upgrade in almost 20 years, raising it to the same grade as Greece.

The second success is infrastructure, where Mr Modi has poured money into roads and railways. India’s cities have been linked up with 50,000km of new main roads, expanding the network by 60% in a decade. Along with the introduction of a national goods-and-services tax (GST), that has created the foundation for an internal market which could one day rival China and America.

Third is digital, where Mr Modi developed reforms initiated by the previous government. As a result, almost all Indians now use Aadhaar, an online-identity system, and other digital-public systems to get government services, and make and receive payments. Last year these transactions almost hit $3trn.

Helped by all this, growth has ticked along at almost 6% a year under Mr Modi (see chart 1). Yet under the bonnet there are problems. The most obvious is that the economy is not creating enough jobs, which risks turning India’s demographic boom into a burden. Government survey data show that labour-force participation has been climbing steadily, reaching 55% last quarter. Yet some analysts worry this is misleading, because it counts unpaid jobs. Almost a fifth of under-30s in cities are unemployed.

The economy has bounced back from the pandemic, but private corporate investment is still weak. In 2024 it was just 12% of GDP, lower than during an investment boom in the 2000s. Ram Singh, a member of the RBI’s monetary policy committee, says a low ratio of capital expenditure to operating margins is a sign that firms lack confidence. Foreign direct investment (FDI) inflows rose to $81bn last year, but that has been offset by higher repatriation and firms exiting the country, which means net FDI has fallen (see chart 2).

And Mr Modi’s successes have been double-edged. His infrastructure splurge has been delivered rapidly, through a handful of favoured national champions. Yet such cronyism probably helps to explain other firms’ unwillingness to invest, says Raghuram Rajan, a former head of the RBI. Digital infrastructure allows politicians to hand money directly to the poor, cutting out the graft of middlemen and helping to reduce poverty. Yet some fear that the model is working too well, encouraging a welfarism that eats into budgets, particularly as state-level politicians grasp its electoral power. Karnataka now spends one sixth of its budget on handouts.

Many in Delhi hope that Mr Modi and Mr Trump will patch things up. V. Anantha Nageswaran, the government’s chief economic adviser, said he believes the impasse “will not continue for too long”, and that the damage will be confined to this financial year. Either way, he thought India’s economy will remain “dynamic”, not “dead”, as Mr Trump claimed.

But if India’s relationship with America remains rocky, these underlying problems will be sharpened. The consequences are most obvious for manufacturing. In Delhi there had been hopes that India was well-placed to benefit as firms sought to diversify their supply chains away from China. The best example was Apple, which already makes one-fifth of its iPhones in India (electronic goods are exempt from American tariffs). Yet if the tariffs on other goods remain, India will be unable to compete with Bangladesh and Vietnam in areas such as garments and textiles.

The ructions have not extended to the IT services and tech industry. If they did, that would be more damaging, given that India depends on America for customers and technology. A broader debate is under way about how AI will shake up the sector. Last month TCS, the country’s largest outsourcer, announced plans to lay off 2% of its workforce—a move some interpreted as a sign that AI could eat Indian firms’ business. Yet others say AI will be a boon for India. “This is the place where you can hire engineers at scale and cheap,” says Ridham Desai of Morgan Stanley, a bank.

Mr Modi has already responded to American bullying. The most serious measure in his speech on August 15th was the simplification of GST, which is complex and vulnerable to fraud. The four main existing rates will be reduced to two. That will come into effect in October, alongside an income-tax cut. This should lift consumption.

On August 19th the government announced the remit of a new committee tasked with making it easier to do business and removing the threat of criminal penalties for even minor mistakes. Sanjeev Sanyal, a member of Mr Modi’s economic advisory panel, points to a bill that will decriminalise more than 300 provisions—including arcane laws that criminalise selling biscuits labelled with the wrong weight. There is talk of the government “dusting off” other reforms that were shelved after the election, says an analyst at a large asset manager.

A burst of deregulation would be the best way to realise another 1991 moment, Anand Mahindra, a tycoon, has suggested. He thinks Mr Modi should also work with states to make India more attractive to foreign investors. Reform of “factor markets”, particularly land and labour, will also be essential. Others note that investment and dynamism are held back by slow-moving courts and regulators.

Even if the appetite for reform is there, Mr Modi faces several big trade-offs. The most obvious is the risk of an electoral backlash. Over the past decade he has repeatedly proposed pro-growth policies only to be rebuffed. Most recently he was stung by a massive wave of farmer protests in 2021, which forced him to abandon agricultural reforms.

Second is the tension between creating a more “self-reliant India” and finding new markets and customers abroad. Speaking after Mr Modi’s speech, Mr Nageswaran insisted the two goals were “not in contradiction”. Yet the risk is that the lasting effect of Mr Trump’s antics will be to push India to turn inwards. India’s bureaucratic machine has long been sceptical of opening up. Insiders say it has regained influence recently.

The third challenge is constitutional. After three decades of top-down reform, India’s biggest problems cannot be solved in New Delhi. Land, labour and agriculture are all either shared or devolved matters. Mr Modi’s method, of trying to bypass the states and force changes through, has not worked. Land reforms were abandoned; new labour codes were passed but not implemented. Many chief ministers of states—with small budgets, high debts, and their own elections to think about—could not see what was in it for them.

This may change. While states such as Gujarat, Karnataka and Andhra Pradesh have long been reform-minded, they were all outpaced last year by Tamil Nadu, which grew at a blistering 11%. This state has attracted the likes of Apple by adopting a pragmatic approach to land acquisition and labour relations. Telangana and Maharashtra, meanwhile, have adopted far-reaching electricity reforms that will end farmers’ entitlement to free power by placating them with solar panels. With this change, says Mr Desai, the states will be able to stablise their budgets and make power cheaper for firms, attracting investment and jobs.

Such developments hold up the prospect of a “competitive federalism” that could spur India’s next phase of growth. Yet to unleash that, Mr Modi would need to embrace fiscal federalism, an approach that goes against his instincts. Speaking on the ramparts of the Red Fort, he said: “If we choose this path, and if everyone chooses it, then no selfish interest will ever be able to entrap us.” Many will be watching carefully to see just what he means. ■