India's Faulty Exceptionalism

India's Prime Minister has been warning Western nations against protectionism, but he should also direct that advice to his own countrymen

So far India seems to be weathering the global economic meltdown better than almost any other country. But this blessing might turn into a curse if it makes India skittish about further opening its economy, especially to foreign investment. If the agenda and rhetoric of the main political parties this election season is any indication, that's a very real possibility.

Unlike in the past when the Indian economy contracted pneumonia every time the global economy sneezed, this time the exact opposite seems to be happening: In the final quarter of last year, the U.S. economy shrank by an annualized rate of 6.2% and the Japanese economy by 12.7%. By contrast, India says its economy grew by 5.3% in the same period. (There is a fierce debate among Indian economists about the reliability of government data, but, with some notable exceptions, there is widespread agreement that the country was among the top performers last year.) Next year, India's economy is expected to grow between 5% and 7%. By contrast, the Organization for Economic Cooperation and Development estimates that the combined gross domestic product of its member developed economies will contract by 4.2% in 2009.

But in the face of all this good news, the emerging wisdom among India's political parties is not that its previous round of liberalization worked and now the country needs to move post-haste toward the next round. Rather, they are suggesting that India's relatively strong economic performance shows that it has struck the optimal balance—open enough to benefit from global upswings and closed enough to avoid global contagions. "This financial crisis might well bring out India's latent but powerful dirigiste impulses," warns Raghuram Rajan, an economic advisor to Prime Minister Manmohan Singh and a professor at the University of Chicago.

India's export sector is small, thanks in part to the country's failure to liberalize its archaic, union-friendly labor laws that have diminished manufacturing productivity. But politicians are now hinting that perhaps underdeveloped exports are not such a bad thing after all, as this has made India less vulnerable than other Southeast Asian economies to plummeting global demand. India also does not rely on foreign investments as much as many Eastern European countries do, which has allowed it to avoid the capital flight those countries are now experiencing.

Indeed, Sonia Gandhi, the leader of the ruling United Progressive Alliance coalition, has been crediting India's ability to withstand the global crisis to her mother-in-law, Indira Gandhi's, "much reviled" nationalization of the banks 40 years ago. Although the ban on private banks has been lifted, roughly 75% of industry assets remain in government hands with tight restrictions on foreign participation and ownership. "Public sector financial institutions have given our economy the stability and resilience we are now witnessing in the face of the economic slowdown," she says. Even more ominous than her remarks—which have been widely lampooned in the press as both politically and economically ignorant—is that Home Minister P. Chidambaram, a key architect of India's liberalization and champion of banking reforms, has been echoing them.

Not to be outdone, L.K. Advani, the octogenarian leader of the opposition Bharatiya Janata Party who is vying to become prime minister, has dusted off an old speech and is once again touting swadeshi, or economic nationalism, as the way forward for India. The current financial crisis, he claims, demonstrates that "unbridled capitalism" is no better a model for India than Soviet communism and he wants the government to maintain aggressive restrictions on the financial sector.

This is a dangerous line of thinking that ignores the huge opportunity cost of financial protectionism, especially for India's most economically vulnerable segments in rural areas.

India has made giant strides in opening its economy since 2002 when the U.S. Department of Commerce rated it as "one of the most closed in the world." It has cut top tariff rates on industrial goods from over 100% before liberalization to 10% now. It has also simplified its byzantine licensing requirements for capital imports. But when it comes to foreign investments, its reforms have been incremental and ad hoc—rather than dramatic and stable.

Although foreign direct investment increased last year, the government severely restricts this investment in allegedly politically sensitive areas such as retail trading, railways and real estate. What's more, foreign companies are allowed to participate in construction projects only if they agree to accept payment in nonconvertible rupees—an obvious dealbreaker. Nor can foreign firms that don't have local collaboration participate in most government contracts—akin to the much-derided "Buy American" provision in America's recent stimulus bill which bars the use of foreign steel and iron in stimulus-funded infrastructure projects. Meanwhile, although 100% foreign ownership of companies in "nonpriority" sectors is allowed in theory, regulatory hurdles make this virtually impossible in practice, according to U.S. Department of Commerce.

Contrary to conventional wisdom, the main victims of such restrictionism are not just businesses and consumers in cities—but the poor in rural India as well.

Indeed, the biggest impediments to the modernization of India's villages are the country's abysmal roads, electricity, and sanitation. However, without a sizeable influx of foreign investment—a huge challenge at any time but especially now when major international banks are staring at red balance sheets—it will be very hard to provide adequate infrastructure.

The Indian government's own estimates show that the country needs to invest anywhere from $300 billion to $500 billion over the next four or five years toward infrastructure enhancements. But the government doesn't have this money given that its total national budget deficit—central and state—is well over 11% of GDP—double that of last year. Nor can the government count on India's high gross savings rate—37.7% of GDP this past fiscal year—to finance such projects. India can't mobilize these savings for long-term projects, as the Economist recently noted, because Indians prefer to put them in physical assets such as homes.

Infrastructure is not the only area where rural India could use foreign help. It also lacks access to basic financial services. The vast majority of villagers don't even have bank accounts, let alone instruments to insure against low crop yields due to bad weather. Nearly three-quarters of farm households have no access to formal sources of credit, leaving them extremely vulnerable to exploitative moneylenders. Their only other option is government banks that—notwithstanding Ms. Gandhi's lavish praise—primarily serve people with either connections or collateral, neither of which poor villagers have.

Making better financial services available to them will require, first and foremost, eliminating mandates that force private banks—whether Indian or foreign—to offer "priority lending" to favored constituencies at sweet rates. It will also require removing the barriers to entry that foreign banks face, such as obtaining government approval to acquire more than a 5% stake in a local bank and restrictions on opening new branches.

India is on the cusp of a major transformation that could make the country's crushing poverty a thing of the past. However this will require a renewed commitment to liberalization. India's parties have a long tradition of dumping their campaign rhetoric as soon as they get elected. This time they should certainly honor that tradition—and throw open India's doors to foreign investment and globalization.

Shikha Dalmia is a senior analyst at Reason Foundation. This article originally appeared in The Wall Street Journal Asia.