The analysis in the earlier sections highlights the services sector role in sustaining the growth rate of the Indian economy during the global economic crisis and the sectors role in building the resilience of the economy. Due to the growing contribution of the sector to GDP and its rising productivity, the services sector has emerged as the most dynamic sector in the economy. Many factors contributed to sustaining the growth of the services sector during the global economic crisis. The low ratio of services exports to GDP and the limited direct exposure of Indian banks to the US mortgage market and stressed international financial institutions considerably reduced the direct impact of the crisis.

Growing domestic demand provided a much-needed cushion to the falling external demand of the last two years. Much of this domestic demand was engineered by an increase in government final consumption when both private final consumption and investments decelerated. The rise in government consumption came in the form of four fiscal stimulus packages. These packages included tax reliefs to boost demand and increased expenditure on public projects to create employment and generate growth in the economy. This has led to an increase in fiscal deficit from 2.7% of the GDP in 200708 to 6.2% of the GDP in 200809.

Apart from counteracting falling private consumption by increasing its expenditure, the Indian Government’s response to the global economic crisis can been seen at various other levels. A number of monetary easing and liquidity enhancing measures have been undertaken, including reductions in the cash reserve ratio, statutory liquidity ratio, and other key rates. The objective has been to ease liquidity in the economy and boost consumer and investor confidence. To fulfill social objectives during the crisis, the government increased its expenditure on social services. The share of social services expenditure in total government expenditure increased from 19% in 200203 to 22% in 200708, and then further to 24% in 200809, of which 11% was spent on health and 5% on education.

In order to maintain the growth-enhancing role of the services sector it becomes important to ensure that the services that contribute relatively more to growth are placed on a higher productivity trajectory. The services identified as a priority by our analysis are software services, domestic trade (retail/wholesale distributive services), and financial services. For these services, a roadmap of specific policies needs to be drawn, not only to support their growth during periods of crisis, but also for accelerating their growth rate in the future. These sectors have shown a remarkable resilience despite relatively less support compared to other sectors. Efforts are required to improve both demand-side and supply-side factors in these services sectors. On the demand side, specific policies are required to improve domestic and external demand, and on the supply side, targeted policies are required to boost productivity growth.

6.1 Distributive Trade (Retail/Wholesale) 9

Distributive trade is an important sector for India as it has the potential to provide employment to a large proportion of the population and significantly contributes to the GDP. However, 98% of trading activities are carried out in the unorganized segment of the economy. A significant impediment in policy formulation in this sector is that the statistics of this segment have not been adequately developed and are lacking in quality, comparability, and timeliness. There is no regular flow of data either from official sources or through annual surveys. As a result, estimates vary widely about the true size of retail business in India.

According to Central Statistics Office estimates, total domestic trade, both wholesale and retail, constituted about 15.1% of India’s GDP in 200607, an increase from 13% of the GDP in 199900. The National Sample Survey Organization’s Employment and Unemployment Survey for 200405 reports employment in the retail trade of around 35.06 million, which constituted about 7.3% of the workforce (459 million). The corresponding retail employment was about 30.62 million in 199900, which means that an additional 4.44 million jobs were added to this sector in the five-year period, 200005, showing an annual employment growth of 2.7% per annum. Wholesale trade, on the other hand, contributed 5.48 million jobs. Indian retail is dominated by a large number of small retailers consisting of the local kirana shops, which together make up the so-called unorganized retail or traditional retail, with a gradually rising organized retail sector. The total number of organized retail outlets rose from 3,125 in 2001 (covering an area of 3.3 million sq. ft.) to 27,076 in 2006 (covering an area of 31 million sq. ft.).

The impact of the global crisis on the retail/wholesale trade sector has been low. In 200708, the sector’s contribution to GDP growth increased 1.42 percentage points, compared to an increase of 1.40 percentage points in 200607. This was in spite of a slight decline in the overall contribution of the services sector to GDP growth from 6.9 percentage points in 200607 to 6.7 percentage points in 200708.

6.1.1 Rising Domestic Demand and Foreign Direct Investment in Retail

The retail sector in India has steadily growing domestic demand, which is explained by a rapidly expanding middle class, sustained high economic growth during the last few years causing a rapid rise in disposable incomes, favorable demographics placing incomes on younger population with less dependency, and growing urbanization. Indian retail sales were about US$322 billion in 200607 (National Council of Applied Economic Research, Market Information Survey of Households ), which amounted to about 35% of India’s GDP. India is now the seventh largest retail market in the world, and the Indian retail industry is projected to grow to about US$590 billion by 201112 and is then to grow to over US$1 trillion by 201617. This implies there is huge growth potential in the country’s retail sector.

Most of the retail sector activities are in the unorganized sector. In 200607, organized retail contributed roughly 4% to the total Indian retail sector, which is very small even compared with most of the emerging market economies. However, the scenario is fast changing. The organized retail real estate sector has grown from a miniscule 0.9 million sq. ft. in 1999 to 28 million sq. ft. in 2006. The growth until now has been rapid at over 60% per annum for the last seven years (although on a smaller base) and is expected to grow at least by 50% per annum in the next four to five years. It is estimated that organized retail will be contributing 16% to the total Indian retail sector by 201112. In this scenario, a lack of domestic demand may not be a serious hurdle to the growth of the retail/wholesale trade sector.

The growing retail sector in India has attracted the attention of many foreign retailers. A.T. Kearney annually ranks emerging market economies based on more than 25 macroeconomic and retail-specific variables through their Global Retail Development Index. In 2005, 2006, and 2007 India ranked number one, indicating that the country was the most attractive market for global retailers to enter. This is indicative of an untapped demand. While restrictions on foreign direct investment (FDI) have been a major deterrent to the entry of foreign retailers in this sector, there has been a calibrated liberalization over the past few years.

To facilitate easier FDI inflow, instead of having to seek Foreign Investment Promotion Board approval, FDI up to 100% is now allowed under the automatic route for cash-and-carry wholesale trading and export trading. FDI up to 51% has also been allowed with prior government approval for retail trade in single-brand products with the objective of attracting investment, technology, and global best practices, which caters to the demand for such branded goods in India. Notwithstanding these measures, restrictions on FDI in retail continue. Besides cash-and-carry wholesale trading, the commonly used channel for the entry of foreign retailers is through strategic licensing and franchising arrangements.

One of the main reasons for the government taking a cautious approach towards the opening of retail trade in India is the existing structure of the retail sector and its capacity for generating employment for unskilled labor. Since a large part of retail activity takes place in the unorganized sector, it absorbs labor across ages, skills, education level, and income class. Retailing with low capital and infrastructure needs is, to a large extent, providing a social safety-net for the economy’s unemployed. This is supported by the fact that the number of self-employed workers in the retail sector is the largest category of labor.

It is widely acknowledged that FDI could benefit the sector tremendously by improving its efficiency, thereby leading to greater integration with the global market and ultimately benefiting consumers by providing price reductions and an improved selection. This may in turn lead to a higher output in the sector and greater growth. However, FDI driven modern retailing is found to be labor displacing and may generate unemployment in a sector that has in the past acted as a safety valve for the economy in terms of employment generation. Thus, in the face of large growing domestic demand, the government is taking a prudent approach towards tapping external demand.

6.1.2 Recommendations for Improving Productivity Growth in Retail

Organized retail has the potential for reducing inefficiencies and improving the productivity of the retail sector. Studies have shown that in the US, organized retail contributed one-fourth of the rise in productivity growth in the period 199599. However, in India, organized retail is less than 4% of the total retail sector. It is expected that organized retail, by forming linkages with the agriculture sector, can lead to productivity growth. Working with organized retail can encourage farmers to (i) improve yields by enabling them to obtain quality supplies, (ii) adopt superior farm technology and practices, (iii) access timely credit at reasonable rates, and (iv) bypass unproductive intermediaries. The tie-up with organized retail may drive small/medium enterprises to become more efficient in order to meet the stringent delivery conditions of the retail market. Private labeling is the creation of brands in the name of modern retailers, and it has already begun in India in the food and grocery and apparel segments and is expected to expand rapidly. Small-scale manufacturers will be the major beneficiaries of private labels. Retail services, if they become more organized, have the potential for improving not only their own productivity, but also the productivity of other sectors, especially agriculture, which is marked by low productivity growth.

In order to increase the size of the organized sector and to encourage people to shift from unorganized retailing to organized retailing, the following policy directions should be considered:

1. The retail sector in India is severely constrained by the limited availability of bank finance. Suitable lending policies need to be designed that will enable retailers in the unorganized sectors to expand, employ better technology, and improve efficiencies. Policies that encourage unorganized sector retailers to migrate to the organized sector by investing in space and equipment should be encouraged.
2. The government must actively encourage the setting up of co-operative stores to procure and stock commodities from small producers. This will address the dual problem of limited promotion and marketing ability, as well as market penetration, for the retailer. The government can also facilitate the setting up of warehousing units and cold chains, thereby lowering capital costs for small retailers.
3. With 3.6 million shops retailing food and employing 4% of the total workforce, the food-retailing segment presents a focused opportunity for the government to catalyze growth and employment. Provision of training in handling, storing, transporting, grading, sorting, maintaining hygiene standards, maintaining refrigeration equipment, packing, etc. is an area where the government can play a proactive role. This could give a substantial boost to the productivity of this sector.
4. Quality regulation, certification, and price administration bodies should be created at district and lower levels for the upgrade of the technical and human interface in the rural to urban supply chain.
5. Competition generates productivity. Calibrated and gradual exposure to competition may lead to productivity spillover effects as domestic organized retailers learn ways of building effective supply chains from the foreign retailers. Some competition has already been induced by the government by allowing entry to foreign firms selling single-brand products. However, domestic organized retailers need to acquire a threshold size to have productivity gains from competition. Incentives to increase the size of domestic retail firms need to be designed.

6.2 Software Services

6.2.1 High Domestic and External Demand

Indian software services comprising ITeS and IT-BPO services have shown remarkable resilience to the global economic crisis. Software services grossed US$47 billion in 200809, growing by 17% from the previous year. This sector is a major contributor to the growth of the economy and has a multiplier effect in terms of export earnings, investments, employment, and overall economic growth. The total employment in the IT services is estimated to have reached 2.0 million in 200708 against 1.63 million in 200607, a growth of 22.7%. This represents a net addition of 375,000 professionals to the industry employee base in 200708. The indirect employment attributed to the sector is estimated to be about 8.0 million in 200708. This translates to the creation of about 10.0 million job opportunities, which can be attributed to the growth of this sector. 10

One of the key features of this services sector is its wide use across the other services sectors and manufacturing industries. This provides a strong domestic demand for the sector. The revenue earned by software services from the domestic market is estimated to be US$11.7 billion in 200708 compared to US$8.2 billion in 200607, a growth of about 42.7%. Along with the existence of a strong domestic demand, the sector has a steadily rising external demand. Indian IT-BPO services are characterized by low costs of operations; a high quality of services; and English speaking, readily available, skilled manpower. Further, a favorable time zone difference with the US and Europe has added to its advantage. This has led to a double-digit growth in exports of IT-BPO services.

The global economic crisis led to a fall in the growth of software services, but the growth in domestic demand cushioned the adverse effects. Domestic demand for both IT and IT-BPO services grew much faster than their exports. A double-digit growth in exports of IT-BPO (29.8%) in a time of crisis reflects the competitive edge of Indian IT-BPO services over other suppliers. At present, India has over 400 delivery centers across 52 countries. This strategy of geographical diversification along with productivity growth and operational efficiency has provided a strong footing to the sector.

6.2.2 Recommendations for Improving Productivity Growth in Software Services

Estimations of productivity growth undertaken for 18 firms for the period 199495 to 200708 are indicative of high TFPG in this sector. If the sample can be taken as representative of the sector, it indicates that productivity growth started in 200001 and has continued. However, in 200809 there was a marked decline in productivity growth, probably because of excess capacity with the lowering of external demand. Most of the productivity growth in the sector can be explained by improvements in technology and efficiency, while change in scale does not seem to have added to the productivity growth.

To sustain the growth of software services, targeted policies and strategies are needed. The sector is already at the frontier of the world and there is a need to capitalize on the gains that growing domestic and external demands offer. The following are some recommendations for sustained improvements for productivity growth:

1. With the changing global situation, especially after the slowdown in the growth rate of advanced countries, the nature of demand for software services (especially IT-BPO) has also begun to change. A recent National Association of Software and Services CompaniesEverest research report shows that the outsourcing needs of buyers are changing with companies focusing on value drivers (integrated delivery models offering scale and value and speedy implementation), minimizing risks, and re-evaluating the sourcing model (re-thinking captive versus supplier mix, evolving risk-reward relationships with vendors, and opting for outcome-based pricing). It is important for IT-BPO services providers to build a strong and unmatched value proposition for themselves in specific, focused, niche segments. Super-specialization segments now need to be explored. Policy incentives need to be built for encouraging IT-BPO services to enter such specialty segments.
2. IT-BPO services are not only increasing their depth by entering super-specialty segments, they are also increasing in width by bringing new areas into their ambit, e.g. legal process outsourcing, clinical research outsourcing, mobile applications, energy efficiency, and climate change. These are new areas that require massive investments and knowledge creation. It is recommended that the government takes initiative and encourages IT firms to enter these areas by creating policy incentives.
3. Along with entering new segments and climbing up the value-chain, what is also needed for the sustained productivity growth of the sector is innovation. In line with providing incentives for R&D activities for the manufacturing sector, the government should also focus on developing incentives for innovations in IT services. Collaborative research between industry, academia, and government needs to be encouraged.
4. The government can give direct support through greater outsourcing and moving away from low-value, high-volume back-office jobs and customer support activities, and instead moving towards higher value offerings by BPO services providers. The government role in expanding the domestic BPO industry is expected to be critical, as it can boost domestic business by taking forward programs such as e-governance and connectivity. This will further increase the growth of the domestic market and inject productivity growth into the economy.
5. The Indian software services sector has the potential to emerge as an IT hub in the region. But for that to happen, it is important for the government to provide opportunities within its various bilateral Free Trade Agreements. Concessions for IT service providers can be negotiated to increase exports and investments in other countries. Low-value end services can be outsourced to these countries and attempts can be made to develop supply chains.

6.3 Banking Services

The share of banking and insurance services of the total services output has remained consistently around 10%, while its share in GDP growth has increased steadily over time. In 2008, India had 88 scheduled commercial banks: 27 public sector banks (banks where the Government of India holds a stake), 31 private banks (banks where the Government of India does not have a stake; they may be publicly listed and traded on stock exchanges), and 38 foreign banks. The banks have a combined network of over 53,000 branches and 17,000 automated teller machines. According to a report by ICRA Limited, a rating agency, the public sector banks hold over 75% of the total assets of the banking industry, with the private and foreign banks holding 18.2% and 6.5%, respectively.

Reforms in the Indian banking sector started in 1991 in order to promote a diversified, efficient, and competitive financial system. The ultimate objective was to improve efficiency and financial viability and undergo institutional strengthening. Beginning in 1992, Indian banks began being gradually exposed to the rigors of domestic and international competition. New banks from the private sector and the entry and expansion of several foreign banks resulted in greater competition in both deposit and credit markets. Consequent to these developments, there has been a consistent decline in the share of public sector banks in the total assets of commercial banks. With time, a stream of literature has evolved in India that explores the performance of financial institutions in the wake of financial liberalization. These studies are essentially micro-economic in nature and seek to analyze the efficiency and productivity of banking systems.

It is expected that privatization will unleash competitive forces. Such competition would, in turn, enable banks to alter their input and output mix. This, when combined with technological developments, facilitates increases in output that raises overall bank productivity and efficiency. This has led to a rising debate on the impact of ownership on bank efficiency, which is based on incentives for being efficient. On one hand, it is argued that private ownership will have more incentives for improving efficiency; on the other hand, it is expected that privatization is, in general, accompanied by an increase in operational costs and could induce financial fragility due to over-expansion of banking activity. Another debate in the area of banking productivity is the relationship between bank size and efficiency, as banking in the current world is technology driven and technological progress itself is scale augmenting. It is argued that productivity gains after privatization could be temporary and not sustainable in the long run. As a result, evidence in support of a unidirectional relationship between privatization and efficiency/productivity is not conclusive.

Most studies have found that TFPG has improved marginally in the post-deregulation period, but there is little evidence of a narrowing of productivity differentials across ownership categories (e.g. Kumbhakar and Sarkar 2003). Among various productivity indicators, labor productivity indicators like business per employee and profit per employee are most commonly used. In addition, business per branch is also used to judge branch-level productivity. Studies have found that profit per employee increased by a compound growth of around 17% in the period 199204 (Mohan 2005). Overall, the balance of evidence suggests distinctive productivity improvements in the banking sector over the reform period.

The TFPG analysis undertaken earlier in this paper for 67 banks over 10 years also indicated a substantial rise in the TFPG of banks. Except for 200708, there has been a continuous increase in bank productivity since 200001. Such an increase could be driven by two factors: technological improvement, which expands the range of production possibilities; and a catching up effect, as peer pressure amongst banks compels them to raise productivity levels. Within the context of gradual deregulation of the financial sector, two main factors may have been at work: a significant shift of the best-practice frontier, driven by a combination of technological advances, financial innovation, and different strategies pursued by banks; and/or reductions in total costs due to improvements in overall efficiency. Results indicate that in different years, different factors have become relatively more important. Although it is difficult to pinpoint the relative mix of these factors in raising productivity, the conclusion is clear: Indian banks have witnessed significant productivity improvements, post-reforms.

6.3.1 Recommendations for Increasing Productivity Growth in Banking Services

Higher sustainable growth is creating greater demand for financial savings. The Indian banking sector faces many challenges with the economy possessing one of the highest growth rates in the world. Not only does the banking sector require increased penetration to reach out to a wider customer base, but it also has to provide the best value to customers in terms of service levels and transparency. Indian banks will have to find ways to optimize each customer relationship as they compete with global players with deep pockets and deep customer insights. To help banks improve their productivity and efficiency and provide much needed support to the industry, our recommendations are the following:

1. Banks not only need to invest in infrastructure but they also need to leverage information technology to find more innovative ways to reach customers, such as utilizing new delivery mechanisms, economizing on transaction costs, and providing better access to the under-served. Electronic transactions substantially improve the efficiency of banking systems because they are faster in comparison with paper-based transactions. To help banks undertake these costs, more deregulation is required.
2. Another critical challenge is the hiring and retaining of talent in the face of stiff competition from private institutions. Banks will also have to invest in new skill development and training. The government can provide vital support in this respect. As the share of public-sector banks is the highest, skill development and training of staff needs to be undertaken at regular intervals to keep them up-to-date with the latest technologies and customer care programs.
3. Indian banks need to build on existing capabilities and also add new ones. This poses a more serious managerial challenge given the dynamic environment in which banks will be forced to continuously learn and reorient themselves while adopting new technologies for risk management, building innovative service mechanisms of delivery, and improving customer care. The consolidation of banks can prove to be an effective tool to achieve this objective. Banks with similar operations have an incentive to merge, thereby eliminating overlapping branches and freeing back office, administration, and marketing resources. Productivity gains from the implementation of new technologies would also be enhanced due to the incurring of large initial investments compared to the scale of operations. This may also lead to risk diversification, which is more relevant for smaller banks concentrated in particular regions serving niche markets. As banks merge and grow bigger they would be in a much better position to introduce customized financial instruments. The government can play a vital role in this through strategic policy intervention.
4. With the implementation and acceptance of Basel II norms, banks would be able to capture operational risks better and, therefore, would need additional capital. This may make them turn increasingly to the flourishing capital market. The government needs to increasingly facilitate this process.

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