Prized mushroom: The success of Infosys (pictured) and other IT firms has been because of their real cost advantage

When we were asked to provide a 15-year forecast of India's economy, we were reminded of former Harvard University dean McGeorge Bundy's warning: There is no safety in unlimited technological hubris. Likewise, there is no certainty in unlimited economic hubris, so let us start humbly by describing what we believe to be the foundation and process of economic growth generally and in India specifically.

In his Presidential Address at the 1998 Annual Meeting of the American Economic Association, the renowned economist Arnold Harberger compared the incidence of real cost reductions and resulting economic growth to the sprouting of mushrooms. Growth in a specific industry drives overall economic growth and driving industries spring up, like mushrooms, randomly over time.

The spore of a mushroom industry is a real reduction in cost. For example, consider factories in India and the United States producing the same product of similar quality with equally skilled labour. Because workers in India are paid less than workers in the US, the Indian factories present an opportunity for real cost reductions. Sometimes, but not always, a real cost reduction sprouts into a mushroom-an industry that has found a way to take advantage of the opportunity to emerge as a driver of economic growth. In the 1920s, car and rubber tyre manufacturers were mushroom industries; in the 1930s, refrigerator manufacturers; in the 1940s, pharmaceuticals; and in the 1990s, the information technology (it) industry.

Predicting which industry will emerge is as difficult as predicting where the mushroom will sprout. As Harberger said, "Mushrooms have the habit of popping up almost overnight".

Finding a Mushroom

The mushroom in India's economy is the IT services industry. When it sprouted is well known. The story of how and why reveals the difficulty in forecasting the emergence of new mushroom industries. During the 1970s and 1980s, India experienced a brain drain as talented well-educated Indians went west, especially to the US, for higher education. Though a small percentage of the general population, those who left were a significant percentage of the population that had been trained in India's prestigious institutes of technology.

The 1980s also happened to be the dawn of the digital era and many of these Indian engineers and others found themselves in the midst of an it revolution. Some became successful Silicon Valley entrepreneurs. With the advent of the internet and fibre optic cable, Indian entrepreneurs took advantage of the relatively low-cost talent pool they themselves had come from several years earlier, and created what came to be the Indian software services industry. When looking back, we find that:

Green potential: Real cost reductions can transform agriculture and agro-retailing sectors if issues like transportation, proper storage and power are addressed	The new mushroom: The conditions seem apt for the auto products industry to sprout. It has been the major driver of growth in exports of engineering goods

Advances in telecommunications technology provided an opportunity for real cost reductions in the it industry globally;

Indian engineers who had left India to further their education and others who remained home took advantage of this opportunity to become it entrepreneurs, utilising India's relatively low-cost, highly skilled labour force to build an industry that quickly became the world's leading provider of it services;

Indian it firms' real cost reductions spurred growth in the Indian economy; and

Growth in India's economy was and still is being fuelled by it-related services industries, including business and knowledge process outsourcing (BPO and KPO), that continue to achieve and take advantage of real cost reductions.

How could one have predicted this sequence and forecast its consequences? India has experienced phenomenal growth driven by the mushroom industry of it services despite being one of the least technologically advanced economies in the world, a country with a large population living in poverty, and a country with a high rate of illiteracy. During the most recent year for which data are available, India's exports of software and services grew 33 per cent. In only eight years, the share of India's GDP accounted for by its IT industry quadrupled from 1.2 per cent to 4.8 per cent.

Clearing Away the Underbrush

If the mushroom metaphor is apt-and we believe it is-much of the recent debate among economists over when and why the Indian economy started to shine is largely irrelevant. The presence of Indian engineers in western economies, advances in communications technology, the availability of highly skilled human capital in India, and advances in and growing use of it in all walks of life were all important conditions leading to the emergence and growth of India's it services industry. But none of these conditions was the result of far-sighted government policy, except, maybe remotely, government investment in higher education oriented towards engineering.

The post-1991 economic liberalisation policies promoting investment in information and communications technology (ICT) infrastructure and reducing foreign exchange and foreign investment regulations allowed the mushroom to continue growing, but these policies were neither the spores of India's it mushroom nor the favourable conditions that led to its early growth. The spore of the industry was its real cost advantage and the industry grew because of worldwide demand for it services. In sum, India benefited from simply being in the right place at the right time.

Are More Ready to Sprout?

It is unlikely that the real cost reductions of India's it services industry will last forever, or even through our 15-year forecast period. There is already an IT skills gap in India. Kiran Karnik, the president of NASSCOM, recently warned of an impending severe shortage of highly skilled workers. The IT industry alone needs more than 300,000 workers and fewer than 150,000 are available each year. By 2010, nasscom warns that India will face a shortage of 500,000 skilled workers. As a result, wages are rising, eroding the cost advantage that led to the industry's growth.

Still mushrooming: But the IT sector faces a shortage of skilled workers, and that could erode its cost advantage

However, the success of the industry has had an important side effect. India has gained global recognition, not as a developing country with a huge population, rampant poverty, and a "Hindu" growth rate, but as a leader in the provision of it services with a burgeoning middle class and tremendous potential for the future.

This recognition has not only opened global markets for Indian industries producing technology products, but, more important, has given Indian entrepreneurs the confidence that they can compete globally and even dominate world markets. This in itself is a real cost reduction, in terms of marketing and entrepreneurial risk.

As a result, absent some unexpected natural catastrophe or government failure, the Planning Commission is probably right about the likelihood of India's economy growing between 8 per cent and 9 per cent on a sustained basis, at least during the period of the 11th Five Year Plan. In fact, our baseline forecast shows India's gross domestic product growing between 8 per cent and 9 per cent until 2018.

But we think new mushrooms are about to sprout. If they do, economic growth will exceed the Planning Commission's target and our baseline forecast.

Looking for Similar Conditions

The next mushroom might be sprouting now in India's manufacturing sector, in industries where conditions are similar to the conditions that gave rise to the it services industry-growing global demand for output, a technology-driven production process, skilled labour requirements, and foreign direct investment (FDI).

During the past two years, growth in manufacturing has spurred growth in India's economy. The two-year average annual change in manufacturing sector production was 9.1 per cent. And this year, the manufacturing sector attracted the most FDI to India-$1.3 billion, nearly twice the amount attracted by the it services industry.

The automotive products industry is the most likely manufacturing mushroom. One hundred per cent FDI is allowed in the industry. There is no local content regulation. The potential domestic market is huge. And foreign markets are a strong source of growth. According to the central bank, exports of India's manufactured engineering goods, a category that includes automotive products, grew at an average annual rate of 33.8 per cent during the most recent three years and 40 per cent of these exports were manufactured by small- and medium-size enterprises. The automotive products industry was the major driver of growth in exports of engineering goods.

Still, several formidable barriers must be removed for any manufacturing industry mushroom to sprout. India's inadequate physical transportation infrastructure, unreliable and costly supply of energy, and high import tariffs stand in the way. And like the it services industry, skilled manufacturing industries face rising wage costs as growth in the supply of skilled labour fails to keep pace with increasing demand.

Looking Elsewhere

A new and significantly faster growth spurt will occur if real cost reductions can be found and captured in agriculture and its related industries, including retailing. These industries employ the vast majority of India's labour force; agriculture alone employs 60 per cent. Real cost reductions that translate into increased output, wages, and lower prices will benefit India's rural poor as well as India's middle class.

But much needs to be in place before agriculture and agro-retailing mushrooms can sprout: better village transportation and storage infrastructure; fairly priced, unsubsidised electricity; modern irrigation to replace tube well irrigation that depletes water resources faster than they can be replenished; and less regulation of India's finance, insurance, and retailing industries.

Now that the government is investing in infrastructure and that foreign competition in insurance, finance, and retailing is more likely, Indian entrepreneurs are beginning to find and take advantage of real cost reductions to transform the agriculture and retail sectors of the economy. Commercial banks are developing rural credit programmes. Large Indian businesses with no experience in retailing are finding real cost reductions by linking farmers directly to urban food stores. And retailers are seeking ways to capture the efficiencies of large stores without sacrificing the intimacy and service of small stores. Prices in small stores are 20 per cent higher than in big stores. In the long run, such increases in purchasing power will generate and sustain higher growth.

Growing Faster

Nobel prize winning economist Robert Solow developed what is popularly known as the Solow growth model. According to Solow's model, GDP growth is determined by growth in the stock of economic capital (plant, machinery, equipment, etc.) and labour. The portion of economic growth not explained by these two factors separately is explained by gains in total factor productivity, the increase in productivity that occurs when capital and labour are combined more efficiently.

Using the Solow model as our framework, we developed two forecasts of GDP growth (see Forecasting Faster GDP... & Forecast Changes in...). In one, the baseline forecast, we assumed that the stock of labour and capital will grow during the forecast period (2006 through 2020) at the rates they grew during the recent past. In the other, the optimistic forecast, we account for additional infrastructure investment spending.

In the baseline forecast, growth will reach a maximum of 9 per cent in 2009 but level off and decline to less than 8 per cent by 2020. Our baseline reveals the diminishing effects of India's current it services industry mushroom.

A good harvest: Agriculture employs 60 per cent of the labour force. Real cost reductions will increase output, wages and lower prices, thus benefiting the rural poor	Future drivers: Better infrastructure in manufacturing, retail and agriculture will help these sectors achieve their true potential. And this will drive economic growth

Without significant investments in India's infrastructure, the true potential of the economy will not be realised. Recall that the common barrier to any mushroom industry emerging is the lack of adequate infrastructure. Prime Minister Manmohan Singh has called for investment totalling $300 billion by 2012. In our optimistic forecast, we account for the Prime Minister's targeted amount of $300 billion by 2012 plus a similar amount over the 2013 to 2020 period.

When accounting for these significant infrastructure investments, annual growth in GDP will be 10 per cent or higher from 2009 through 2014, peak at 11 per cent in 2012, and maintain a rate of 9 per cent or higher throughout the remainder of the forecast period.

Infrastructure investments will open the door for real cost reductions, especially in manufacturing, agriculture, and retail trade. Growth in these industries will drive overall economic growth. The real cost reductions that will be achievable with better infrastructure will allow India to reach what we believe is its true potential.

In our optimistic forecast, we expect the mix of industry activity to be changing (see Forecast Changes in...). The services sector, which includes trade, hotels, transport, and communication; financing, insurance, real estate, and business services; community, social, and personal services; as well as construction, already accounts for 60 per cent of total economic activity. The sector accounts for three-fourths of India's GDP growth.

By the end of our forecast period, we expect the service sector will account for 73 per cent of India's GDP. The amount of GDP accounted for by the remaining two sectors, agriculture and industry, will decline over the period. Agriculture's share of GDP will fall from 20 per cent to 10 per cent. Industry's share will fall from 19 per cent to 17 per cent. Implicit in these changes is recognition of the significant growth potential in transportation, retailing, hotels, financing, real estate, and construction industries that will occur with infrastructure investments that allow real cost reductions to emerge, mushrooms to sprout, and employment opportunities for low-skilled workers to grow.

Humility and the Mushroom Hunter

During the next 15 years, we believe India's economy will grow significantly faster than its current rate. How can it not? Success so far has been achieved despite woefully inadequate infrastructure and the misplaced faith of many that governments, not markets, provide opportunity.

With continuing development of basic infrastructure; ongoing innovation in communications technologies; entrepreneurial spirit spreading into manufacturing, agriculture, finance, and retailing; and rising awareness of the potential of markets freed from trade quotas, price controls, and industry protection, a new mushroom is likely soon-but where?

Data lead us in the direction of the automotive and automotive parts manufacturing industry. Foreign demand is important to this industry, but domestic demand is increasingly fuelling its growth and is likely to sustain growth thanks to the burgeoning purchasing power of the Indian middle-class.

In fact, the growth of India's economy as a whole in the next 15 years depends on domestic demand, and especially demand among poor consumers, who outnumber the middle-class three to one. In our forecast, 290 million Indians who lived below the national poverty line in 2000 will be living above the line, perhaps as early as in 2016 (see GDP Growth and... ).

The domestic market holds far more potential than global markets for India's economic future. If mushrooms sprout in agriculture, agro-retail and labour-intensive manufacturing, the purchasing power of India's poor will increase, boosting demand and stimulating faster economic growth.

Recall though that there is no certainty in economic hubris. If gains from any mushroom are perceived to be distributed unfairly, if governments act on the belief that mushroom industries can be "engineered," or if voters expect governments to contrive real cost reductions that arise only from a natural organic process, faster growth will not be achieved.