Objectives and Approach

The purpose of this study was to identify and prioritise the measures that would
help accelerate Indias economic growth. As we have said, Indias GDP per capita,
the best measure of economic performance, is only 6 per cent that of the US and
50 per cent that of China. Of the two components that make up GDP per capita,
employment per capita and labour productivity (output per employee), increases
in the former will yield only small increases in GDP per capita. Our focus was
thus on labour productivity in India, more specifically, on estimating current
productivity levels and determining how they could be improved. To do this, we
analysed Indias output and productivity gap vis--vis output and productivity in
the US and in other developing countries.
In this chapter we explain our approach to this study and the methodology behind
our analyses and conclusions.

APPROACH TO THE STUDY

The main focus of our work was on building a microeconomic understanding of
the performance of 13 sectors in Indias economy, encompassing agriculture,
manufacturing and services, that would be considered representative of the major
sectors of the Indian economy, and then extrapolating these findings to determine
overall productivity levels.
Having done this, we benchmarked the productivity of Indian industry with that of
the best performing economies in the world. We then identified the main barriers
to productivity growth and to the productive investments necessary for output and
employment growth in each sector. By synthesising the results from the 13 case
studies, we drew conclusions on the actions needed to improve Indias economic
performance.
As we have said, productivity growth is the key determinant of GDP growth
(Exhibit 2.1). More efficient use of resources allows the economy to provide
lower cost goods and services relative to the income of domestic consumers and
to compete for customers in international markets. This raises the nations
material standards of living (Exhibit 2.2). Productivity growth is also the key
determinant of higher firm profitability if there is free and fair competition (see
Productivity and Profitability).
The main debates on improving Indias economic performance have centred
around the importance of privatisation, improving infrastructure, reducing the
budget deficit, containing corruption and liberalising labour laws. However, the
1

bulk of the discourse has neither been conclusive, nor led to a successful reform
agenda. It has focused mainly on Indias aggregate performance without studying
specific industries that collectively drive the performance of the national
economy. In contrast, we believe that systematically analysing the relative
importance of determinants of productivity in a representative set of sectors is
crucial to understanding the nature of Indias economic problems and to
providing convincing evidence to help prioritise reforms.
Our work has emphasised the economic barriers to Indias prosperity in the
medium and long term. We have not addressed the short-term macroeconomic
factors that may affect economic performance at any given moment. In drawing
policy implications from our findings, we bore in mind that higher material living
standards are only one of many policy goals that a government can have. We
believe, however, that higher productivity and output levels release resources that
can be used to address social challenges more effectively.

STUDY METHODOLOGY
The research and analysis in this study are based on the methodology developed
by the McKinsey Global Institute (MGI) and consist of two main steps. First, we
reviewed the data on the countrys overall economic performance as well as
current opinion on the factors behind it as expressed in existing academic and
official documents. This allowed us to capture the current understanding of the
factors in past productivity, output and employment patterns in India. Having done
this, we compared Indias performance with that of the US and other developing
countries to provide a point of departure for our case studies.
Second, we used industry case studies to highlight the economic factors that
explained the performance of different sectors of the economy. Then, by looking
at common patterns across our case studies, we identified the main barriers to
productivity and output growth in India. In doing so, we estimated the impact of
removing such barriers on Indias GDP and employment as well as on the
required levels of investment (Exhibit 2.3).
Sector case studies
The core of the research project was a detailed analysis of 13 agriculture,
manufacturing and services sectors. We selected sectors that covered around 26
per cent of Indias output and 24 per cent of its total employment (Exhibit 2.4)
and represented the following key areas of its economy: agriculture: wheat and
dairy farming; heavy manufacturing: steel and automotive assembly; light
manufacturing: dairy processing, wheat milling and apparel; infrastructure sectors
with large investment requirements: electric power and telecommunications; a
domestic sector with a large employment component: housing construction;

service sectors critical to any modern economy: retail, retail banking and the hitech software sector.
In each of the sectors we followed the same two -step process: (1) measuring
current productivity relative to world benchmarks and Indias potential at current
factor costs (see Interpreting Global Productivity Benchmarks); (2) generating
and testing hypotheses on the causes of the observed gap.
Measuring productivity: Productivity reflects the efficiency with
which resources are used to create goods and services and is measured
by computing the ratio of output to input. To do this, we first defined
each sector in India such that it was consistent with the comparison
countries, making sure that our sectors included the same parts of the
industry value chain. We then measured the sectors output using
measures of Purchasing Power Parity and adjusted value added or
physical output. We measured labour inputs as number of hours worked
and capital inputs (used in steel, power and telecom) as capital services
derived from the existing stock of physical capital (see Appendix 2A:
Measuring Output and Productivity). We measured labour productivity
in all 13 case studies and capital productivi ty in only the most capitalintensive sectors, i.e., steel, power generation, power transmission and
distribution and telecommunications.
Given the lack of reliable statistical data in some sectors, we
complemented official information with customised surveys and
extensive interviews with customers, producers and regulators (Exhibit
2.5). This methodology was particularly helpful in deriving bottom-up
productivity estimates in service sectors such as housing construction,
retailing, retail banking and software, where traditional sources of
information are particularly unreliable and incomplete. Finally, given
the size of the Indian Territory, we also conducted over 600 interviews
in different cities to account for regional performance differences.
These interviews were particularly helpful in sectors such as wheat
farming, dairy farming and retail, where local policies (especially as
they relate to soil conditions and land use) are a crucial determinant of
competitive intensity.
Generating and testing causality hypotheses: To explain why levels
of productivity in India differ from the benchmarks, we started by
generating a set of hypotheses on the possible causes of low
productivity. In explaining this productivity gap, we also estimated the
productivity potential of each sector given Indias current low labour
costs. This is the productivity level that India could achieve right now
making only investments that are currently viable. This productivity
potential takes into account Indias low labour costs compared to the
US, which limit the amount of viable investments.

In this phase, we drew on McKinsey & Companys expertise in many industries

around the world, as well as on the expertise of industry associations and
company executives in both India and the benchmark countries. By using a
systematic framework, we captured the major causes of productivity differences
across countries. This framework has three hierarchical layers of causality:
differences in productivity due to practices followed in the production process;
differences arising from industry dynamics; and differences due to external
factors, that is policy and regulatory prescriptions, that explain why the choices
of Indian companies differ from those in the comparison countries (see
Appendix 2B: Defining a Framework).
Synthesis and growth potential
Having identified the causal factors for each industry, we compared the results
across industries. The patterns that emerged allowed us to determine the causes
of the aggregate productivity gap between India and the comparison countries, as
well as the potential for productivity growth in different sectors if external
factors were removed. We also estimated the total investment that would be
required to reabsorb displaced labour.
Estimating the expected evolution of output by sector was key in determining the
required investment rate. Taking into account the potential to improve capital
productivity at the sector level, we first estimated the investment requirements
for each of our 13 sectors. We then scaled up the results to the overall economy
taking into account the expected output evolution. We calculated output growth at
the sector level from benchmarks of domestic consumption growth and of the
additional output that could be expected from exports.
Finally, we estimated the resulting evolution in employment. We then
extrapolated our productivity and output growth estimates to the overall
economy, for each sector, to obtain average productivity growth, GDP evolution
by sector and, hence, the employment evolution by sector.
We then tested the feasibility of our overall estimates and assessed the impact of
each policy scenario on the countrys investment levels, skill requirements, fiscal
deficit and balance of payments situation. This allowed us to assess the relative
importance of different barriers and formulate the specific reforms that would
place India on a high growth path.

Appendix 2A: Measuring output and

productivity
Productivity reflects the efficiency with which resources are used to create value
in the marketplace. We measured productivity by computing the ratio of output
produced in a year to inputs used in that production over the same time period.
Output (value added)
GDP can be seen as the sum of all the value added across sectors in the economy.
In other words, the GDP of a country is the market value of the final goods and
services produced. It reflects the market value of output produced by means of
the labour and capital services available within the country.
For a given industry, the output produced differs from the traditional notion of
sales. Sales figures include the value of goods and services purchased by the
industry to produce the final goods or services (for example, milk purchased by
dairies to produce pasteurised milk). In contrast, the notion of value added is
defined as factory gate gross output less purchased materials, services and
energy. The advantage of using value added is that it accounts for differences in
vertical integration across countries. Furthermore, it accommodates quality
differences between products, as higher quality goods normally receive a price
premium that translates into higher value added. It also takes into account
differences in the efficiency with which inputs such as energy are used.
In the case study of the retail industry, we used the value added measure of output
while for software we used total sales. One complication that could arise is that
value added is not denominated in the same currency across countries. As a
result, this approach requires a mechanism to convert value added to a common
currency. The standard approach uses Purchasing Power Parity (PPP) exchange
rates, a topic which is discussed separately below.
In sectors where prices for inputs and/or outputs are distorted, we used physical
production as a measure of output. This was the case in dairy farming, wheat
farming, steel, automotive assembly, dairy processing, wheat milling, apparel,
electric power, telecommunications, housing construction and retail banking. To
make our measures comparable to our benchmark countries, we needed to adjust
for the product variety and quality differences across countries. This approach
also required data from the same part of the value chain in every country: In some
countries an industry may simply assemble products while in others it may
produce them from raw materials. Physical measures would tend to overestimate
the productivity of the former, as fewer inputs would be required to produce the
5

same amount of output. To overcome these problems, our adjusted physical

output measure accounts for differences in quality and relative differences in
energy consumption.
Purchasing Power Parity exchange rate
To convert value added in different countries to a common currency, we used
PPP exchange rates rather than market exchange rates. PPP exchange rates can be
thought of as reflecting the ratio of the actual cost of purchasing the same basket
of goods and services in local currencies in two countries.
The reason for not using the market exchange rate was that it only reflects
international transactions; it cannot reflect the prices of non-tradeable goods and
services in the economy. Furthermore, comparisons made on the basis of market
exchange rates would be affected by fluctuations in the exchange rate resulting
from, say, international capital movements.
For our aggregate survey and some of our cases, we used PPP exchange rates
reported by the United Nations and by the Economist Intelligence Unit. In
principle, as long as the products are in the same market, we only need the PPP
for one product and can use the market relative prices to compute the PPPs for
the rest of the product range. In cases where the PPP exchange rates were not
readily available, they were constructed bottom up by comparing the actual
market price of comparable goods and services across countries, and then
aggregating the individual prices up to a price for sector-specific baskets of
goods and finally the total GDP.
Finally, we adjusted our PPP rates to exclude sales tax and other taxes and
accounted for different input prices in order to obtain a Double Deflated PPP,
which is the PPP exchange rate ultimately used in our value added comparisons.
Inputs
Our inputs consist of labour and capital. Labour inputs are the more
straightforward to measure: we sought to use the total annual number of hours
worked in the industry by workers at the plant site. When actual hours were not
available, we estimated labour inputs by multiplying the total number of
employees by the best available measure of average hours of work per employee
in the sector. In the case of India, we also needed to account for additional
services provided by some companies that are not usually provided by companies
in the benchmark countries. These included social and recreational services for
workers that are still to be found in some Indian factories (mainly in heavy
manufacturing, e.g., townships provided by steel companies) and are a legacy of
pre-reform times. In these cases, detailed data on workers occupation was
needed in order to subtract them from the labour inputs figures used in our
productivity calculations.
6

In the steel, electric power and telecommunications case studies we also

measured capital inputs. The heterogeneity of capital makes measuring capital
inputs more difficult. Capital stock consists of various kinds of structures (such
as factories, offices and stores) and equipment (such as machines, trucks and
tools). The stock is built up incrementally by the addition of investment (business
gross fixed capital formation) to the existing capital stock. Each piece of capital
provides a flow of services during its service life. The value of this service is
what one would pay if one were leasing this asset and this is what we used as our
measure of capital inputs. To estimate the current value of capital stock we used
the real Gross Fixed Capital Formation data provided by the Annual Survey of
Industries published by the Central Statistical Office (CSO). In certain instances,
such as the telecommunications sector, the CSO data did not match our sector
definition. In this case, we used a bottom-up approach and constructed the
capital figures from the companies balance sheets.
Once we had measured capital stock, we constructed our capital service measures
using the Perpetual Inventory Method (PIM). We based our estimates on US
service lives for structures and equipment. Although ideally we would have liked
to measure the capital inputs in each of our case studies, we concentrated on the
steel, electric power and telecommunications industries since they were the most
capital-intensive sectors in our sample. For the remaining case studies, we
treated capital as a causal factor in explaining labour productivity.

Appendix 2B: Defining a framework

To arrive at a detailed understanding of the factors that contributed to the gap
between current and benchmarked productivity, we used a framework
incorporating causes of low productivity at three levels: in the production
process; in industry dynamics, i.e., the conduct of players in the industry; and in
the external factors that shape managerial decisions, i.e., policy and regulation.
Possible barriers to high productivity are also described to explain the
importance of each cause and to introduce some of the barriers that are presented
in the later discussions.
Production process
The first set of factors affecting productivity arise in the production process and
can be grouped into operations, product mix/marketing and production factors. It
is important to remember that factors in the production process are in turn
determined by elements of a firms external environment that are beyond its
control and decisions made by its managers.
Operations: A large number of operational processes determine

productivity. They are:

Organisation of functions and tasks: This is a broad category
encompassing the way production processes and other key functions
(product development, sales, marketing) are organised and run. It
reflects managerial practices in most areas of the business system
as well as the structure of incentive systems for employees and
companies.
Excess labour: These are workers who could be laid off
immediately without any significant change to the organisation of
functions and tasks. It also includes the variable portion of workers
still employed despite a drop in output.
Design for manufacturing (DFM): DFM is the adoption of
efficient building or product design by using an optimal site/plant
layout, then using standard, interchangeable and cost competitive
materials.
Capacity utilisation: This represents the labour productivity
penalty associated with low capacity utilisation given the fixed
proportion of workers (i.e., management, machine operators,
maintenance, etc.).
8

 Suppliers: Suppliers can contribute to industry productivity through

efficient delivery, collaboration in product development or products
and services that facilitate production (e.g., material suppliers in
residential construction). They can cause productivity penalties
through lower quality supplies or services and fluctuations in the
delivery of inputs.
Marketing: Within product categories, countries may differ in the
quality of products made. Production of higher value added products
or services using similar levels of input is reflected in higher
productivity (e.g., branding in software services). Another source of
productivity differences within product categories is product
proliferation (e.g., the variety of Stock Keeping Units SKUsin
retail). A wide range of product or service lines can reflect a suboptimal product mix that reduces productivity. Finally, both within
the manufacturing sectors and in services, design can influence
which technology might be applied. Design changes might simplify
the production process and improve productivity.
Labour skills and trainability: This factor captures any possible
labour productivity penalties due to lower frontline trainability
potentially caused by lower educational levels, different educational
focus (discipline/skills), low frontline worker motivation, lack of
incentives/possibility for top management to impose changes. It is
also a factor when (older) workers/middle management find it
particularly difficult to break old habits.
Product/Format mix: Countries may differ in the categories of

products they demand or supply, and a productivity penalty can arise if a

countrys output consists of a higher share of inherently less productive
product or service categories (such as mud houses in housing
construction). Demand for such output is mainly the result of
consumers inability to afford inherently more productive products
(such as brick houses).
Technology: The choice and use of technology affects productivity

through three factors:

Lack of scale: Higher production scale generally leads to increased
productivity if fixed assets are a large enough proportion of total
costs. We use capital in the sense of physical assets and their
embodied technologies (such as machines, plants, buildings and
hardware). We classify assets as being sub-scale when they do not
reach the minimum efficient scale.
Lack of viable investment: This refers to investment in upgrading
as well as new investment that would be economical even with
Indias low labour costs. For our calculations, we applied current
wage levels and a weighted average cost of capital (WACC) of 16
9

per cent typically used by domestic and foreign corporations in

India.
Non-viable investments: This refers to investment in upgrading
assets as well as investment in green field operations that would not
be economical given Indias low relative labour costs. As a result,
this category includes investments that are not being made only
because of the lower relative cost of labour (such as full packaging
automation).
Industry dynamics
The competitive pressure in the industry influences management decisions to
adopt best practices in production. We studied the influence of three factors:
Domestic competitive intensity: This refers to differences in the

industry structure and the resulting competitive behaviour of domestic

players. Other factors being equal, more competition puts more
pressure on management to adopt more productive processes.
Industries with high competitive intensity typically experience frequent
entry and exit of players as well as changes in prices and profitability.
Exposure to best practice: This includes competitive pressures from

foreign best practice companies either via imports or through foreign

direct investment (FDI).
Non-level playing field: In a well regulated and well functioning

market economy, the same laws and rules (such as pricing, taxation)
apply to different players in the same industry, ensuring that
productivity levels will determine who succeeds and who fails.
Conversely, in markets where regulation is differentially applied,
companies can often ignore productivity pressures since less
productive firms may flourish at the expense of more productive ones.
External factors
External influences on productivity relate to conditions in the economy or policy
and regulatory prescriptions that determine how companies operate. These
factors are largely outside the control of firms and include:
Macroeconomic conditions (e.g., labour costs or income levels):

To illustrate, for a given level of capital costs, where labour costs are
low relative to capital, managers will use less automated production
processes. This could reduce labour productivity. Low incomes may
lead to the consumption of inherently less productive products and
services hampering the countrys overall productivity.

10

 Macroeconomic barriers: Policy and practice within the overall

economy can have a negative impact on productivity. For instance, large

public budget deficits increase the cost of funds for private investors,
since the governments need to borrow to make up the deficit pushes up
interest rates. Furthermore, the general economic environment in which
managers operate affects their planning horizon, investment decisions
and everyday operational decisions. Investments are more difficult to
commit to in an unstable macroeconomic and political environment
where high inflation rates, uncertainty about exchange rates, or
frequently changing fiscal policies generate additional uncertainty. This
instability leads to higher capital costs (for domestic investors) or
higher country risk (for foreign investors). These higher discount rates
will lead profit-maximising managers to choose different production
technologies, resulting in labour and capital productivity differences
across economies.
Capital markets: Distortions in the capital market (such as

administered interest rates) result in an inefficient allocation of capital

across sectors and firms and will distort the markets ability to reward
productive firms.
Government ownership: The amount of pressure from owners or

shareholders can influence the rate at which productivity is improved.

Companies under government ownership are often not under much
pressure since they receive subsidies that allow them to compete
against more productive players.
Labour market: How the labour market is regulated as well as the skill

levels within it also affect productivity. Labour regulations may

influence the implementation of productivity improvements (e.g., by
restricting efforts to reduce excess workers). With regard to skills,
managers and frontline workers in one country may have lower levels of
education or a different educational focus (discipline/skills) than those
in other countries. This may lead to lower frontline skills/trainability,
resulting in lower productivity.
Product market: Regulations governing different sectors of the

economy can pose barriers to productivity growth (Exhibit 2.6). They

include:
Entry barriers: Regulations prohibiting or discouraging
investment in certain services, products or players can lower the
productivity of a sector. These include restrictions on the size of
players (e.g., the reservation of products for manufacture by small
scale industry), origin of players (in the form of trade barriers and
restrictions on FDI) or type of player (e.g., licensing in dairy
processing that prevents new private players from entering in certain
areas).
11

 Competition distortions: Regulations can distort competition by

subjecting players to differing rules. These include direct tax breaks
and/or subsidies for certain kinds of players, such as small-scale or
government-owned firms. They also include regulations that limit or
distort competition by protecting or favouring incumbent companies
(as in the telecom sector). Similarly, regulations prohibiting or
discouraging certain products or service offerings (including
regulations on pricing) can harm productivity, for example, by
forcing farmers to sell through intermediaries.

Lack of enforcement: Unequal enforcement of tax (as in tax

evasion by small retailers) as well as other acts of omissions (such
as the lack of enforcement of intellectual property rights in
software) also distort competition. As an example, uneven
enforcement of energy payments among different kinds of players
will also create differences in costs and value added. This is
particularly relevant in energy intensive manufacturing sectors such
as steel.
Other product market barriers: Other policies and practices that
can harm productivity include:
Standardisation: Although many firms and consumers benefit
from standards, individual firms often do not have sufficient
incentive to promote a standard. Government intervention is
often required (for instance, in quality standards for construction
materials) on the grounds that the society does not yet have the
means or incentives to invest in standardisation.
Threat from red tape/harassment: Excessive red tape and
regulatory harassment increase costs through the time and other
investments needed in negotiating complex procedures, limiting
the incentives of firms to optimise operations.
Land market barriers: Distortions resulting from the tax system or
regulations relating to land use can prevent efficient use of land.
Examples are low property taxes, stringent tenancy laws, discretionary
procedures for government procurement contracts and land allocation.
Another barrier is a defective system of land titles, which prevents the
formation of an efficient land market thereby distorting the allocation
of land among players.
Problems imposed by related i ndustries: Supplier or downstream

industries can hamper productivity by reducing the competitive

pressures on industry players. An underdeveloped upstream industry can
also impose significant productivity costs by failing to provide products
or services that facilitate production or by delivering lower quality

12

goods or services and/or at irregular frequencies (e.g., irregular milk

supply to dairy processors).
Poor infrastructure: This includes issues in the countrys

infrastructure such as roads, transportation and communications. As a

related sector, infrastructure can affect productivity either through the
demand side (for instance in inefficient distribution) or through the
cost side (e.g., in input procurement).
Other barriers: Markets within different countries may vary in the
structure of consumer demand as a result of varying climates, tastes, or
traditional consumption patterns. This influences the product mix
demanded, which can affect the value of the total output and thus
productivity. Productivi ty penalties may also arise through the structure
of costs as a result of climatic, geographical and geological differences
across countries.

13

Box 1

PRODUCTIVITY AND PROFITABILITY

Within any given market, a firm that is more productive will enjoy higher profitability unless it
suffers from some other source of cost disadvantage. A more productive firm will either
produce the same output with fewer inputs and thus enjoy a cost advantage, or produce better
output with the same inputs and thus enjoy a price premium.
Over time, the higher profitability of productive firms will attract competition. As competitors
catch up in productivity, profitability will tend to converge. In such an environment, the only
way a firm can enjoy higher profitability is by pushing the productivity frontier beyond its
competitors. If, as a result, the firm achieves higher productivity, it will enjoy higher
profitability only until its competitors catch up again. In other words, profitability, in a dynamic
world, is a transient reward for productivity improvements. This linkage holds within a given
market, unless the playing field is not level, i.e., competition is distorted. As we explain below,
an uneven playing field is one of the more important factors in explaining Indias productivity
gaps.
While a more productive firm will enjoy higher profitability within a given market, this may not
be true for firms operating in different markets, for two reasons. First, higher cost of inputs
may render a productive firm in one market unprofitable, while a less productive firm in
another market with lower cost of inputs may be profitable. For example, a US firm may be
more productive but less profitable than an Indian firm because US wages are higher.
Second, competitive intensity may differ across markets so that a productive firm in a highly
competitive market may be less profitable than an unproductive monopolist or oligopolist in
another market. To illustrate, in the 1980s, European airlines enjoyed higher profitability than
their more productive US counterparts because they faced much less price competition.
However, deregulation and globalisation are eliminating distinctions between national markets.
As barriers are removed, productive firms will enter markets with unproductive incumbents.
This could take the form of exports if goods are traded. While cheap input prices may
temporarily shield unproductive incumbents in the importing country, they are not sustainable in
the long run. The cost of capital (a key input price) is converging internationally, and wages
(the other key input price) will eventually catch up with productivity (so that no country can
enjoy both low wages and high productivity in the long run). The other form of market entry
for productive firms is foreign direct investment. In this case, productive transplants will face
the same input prices as unproductive incumbents and will therefore enjoy higher profitability.
In sum, as markets liberalise and globalise, the only sustainable source of higher profitability
for a firm will be to continually achieve productivity higher than that of its competitors.

14

Box 2

INTERPRETING GLOBAL PRODUCTIVITY BENCHMARKS

To assess the performance of Indian industries, we compared their labour productivity levels
with those of the best performing economies in the world. This benchmark allowed us to
measure the existing efficiency of the production processes of Indian companies relative to
their potential efficiency. The comparisons also allowed us to identify the reasons for the
productivity gap through a detailed comparison of production processes and other business
practices in India and the benchmark country.
The global benchmarks should not be perceived, however, as a measure of maximum possible
productivity levels. At any given moment, there are individual companies with productivity
levels above the average of the best performing economy. And over time, the global
benchmark rises as individual companies continuously improve their productivity. So while the
benchmark productivity level can be interpreted as a realistically achievable level of efficiency,
it should not be seen as a limitation.
Independent of the global benchmark for any specific sector, we have chosen to express all
our productivity measures in consistent units defined relative to the US average productivity
level. The US has the highest real income level among large countries, which makes it the
benchmark for the level of total GDP per capita. While this is not the case for several
industries, we believe that using a consistent benchmark unit helps the interpretation of
productivity gaps in individual industries and facilitates performance comparisons across them.

15