Prime Minister Narendra Modi seems to understand what’s holding India back. Now he’s got to figure out the right solutions for this vast and complicated nation.
The focus on China, and its seemingly inexorable rise, means that India, the other Asian giant, often gets neglected. That’s unfortunate: What happens on the subcontinent matters to us all. It’s the world’s biggest democracy. With a population of about 1.3 billion, it has more people than the U.S., the European Union, Russia, and Brazil combined. And according to a new World Bank study that adjusts for the lower prices in the developing world, it’s already the third-largest economy in terms of purchasing power (behind the U.S. and China).
Lately, though, the “Indian miracle” has been sputtering, and the big question hanging over the country’s new Prime Minister, Narendra Modi, is how to revive it. Some accounts frame the India policy debate as one of free-market enthusiasts, such as Jagdish Bhagwati, a well-known Indian-American economist at Columbia University, vs. pro-government dirigistes, who include Harvard’s Amartya Sen, a Nobel Prize winner in economics. But this characterization is too simplistic. India isn’t a test tube, where rival economic theories can be tried out painlessly. It’s a vast and complex place, combining pockets of ultra-modernity with great swaths of poverty and underdevelopment.
To overcome its problems and become a truly modern country, India needs more free-market reforms and more effective government interventions to improve the education system, build infrastructure, promote social inclusion, and strengthen the rule of law. One set of reforms without the other is unlikely to work–that’s the message from a previous generation of “Asian tigers,” such as Japan and South Korea, which pioneered a hybrid growth model that combined competition and openness to the global economy with a good deal of government direction.
The Asian-tiger model involves starting at the bottom of the international value chain–labor-intensive manufacturing–and gradually moving up, so you end up with powerhouse international companies like Toyota and Samsung. India, for all its success in areas like technology services, has largely missed out on the basic manufacturing stage, which is what soaks up the rural poor and produces a platform for subsequent development. With Chinese wages rising, international companies should be moving production to India, but it lacks transport links, reliable power generation, and other basic amenities. Much business activity is still plagued by bureaucracy and corruption. And the financial sector, a mix of public and private interests, is overleveraged and saddled with bad loans.
Judging by his public comments, Modi understands this. He says India has much to learn from countries like China and South Korea. As the chief minister of Gujarat, a big Indian state, he built modern highways, attracted international companies, and put some basic government services online, which helped reduce corruption. Mimicking these tactics on the national level won’t be easy, though. In India’s federal system, strong state governments do largely as they wish. The central administration is relatively weak, partly because of an inadequate tax base, which leaves it permanently struggling to pay its bills.
Still, with Modi occupying the Prime Minister’s office and Raghuram Rajan, a widely respected University of Chicago economist, running the Reserve Bank of India, businesspeople and investors are optimistic. Since last summer the Indian stock market has risen by about a third, and the value of the rupee has stabilized. With Rajan keeping interest rates steady, GDP growth is unlikely to accelerate much in the short term. (The IMF is predicting 6.4% in 2015, up from 5.4% this year.) That may disappoint some of Modi’s supporters, but the key thing is what he does to raise India’s long-term growth potential. His ability to make good on promises of reform will help determine whether the country is Asia’s next tiger–or becomes a plodding elephant.
John Cassidy is a Fortune contributor and a New Yorker staff writer.
This story is from the June 30, 2014 issue of Fortune.