A shocking election upset means India must spend heavily on social needs. Is this the end of the boom?

The vigil on the evening of May 18 outside 24 Akbar Road, the New Delhi headquarters of the Indian National Congress party, was emotional. Stunned at their leader Sonia Gandhi's decision to forego India's premiership, party loyalists, wearing their trademark white, home-spun cotton pants and tunics, pleaded for her to change her mind, shouting "Sonia Gandhi will come and bring her new light!" One worker tried to kill himself. Inside India's parliament, meanwhile, one weeping Congress legislator after another took the microphone to beg Gandhi on national TV to seal their victory over the ruling Bharatiya Janata Party and lead the next government.

The pathos on display makes great theater. But make no mistake. Political insiders, the business community, and investors are breathing a huge sigh of relief over Gandhi's decision to gracefully decline India's top job. Instead, she backed Manmohan Singh, 71, one of India's great economic heroes. As Finance Minister from 1991 to 1996 under Prime Minister Narasimha Rao, the white-bearded Singh rescued India from financial crisis and put its old socialist economy on the path to free-market reform.

Whether Gandhi made her move out of shrewd calculation or simple magnanimity, it was a political masterstroke. In one swoop, she eased many of the wrenching doubts about India's future that have roiled the markets and political analysts. The Italian-born wife of slain former Prime Minister Rajiv Gandhi defused a potentially paralyzing backlash by the outgoing BJP, which still holds one-quarter of legislative seats and represents nationalist Hindus, who objected to a foreign-born leader. Gandhi will still control Congress, however, and by sacrificing the top post in her moment of triumph, she may enhance her national political power by attaining a moral stature that has eluded her for years.

By handing the reins to one of India's most revered economic gurus, meanwhile, Gandhi helped assure the markets the nation remains serious about reform, promoting investment, and sound finances. She also assured the Left that New Delhi would place high priority on basic education, rural infrastructure, and job creation to tackle massive poverty. "The message to the market is, our government will give importance to balanced social and economic development," Singh declared. "There is no need to panic." Investors agreed. Stocks recovered by 11% on May 18 and 19, nearly erasing a record sell-off over the previous two days that wiped out $52 billion in market value. "India's back in the game in a bigger way than ever before," says Surjit S. Bhalla, an influential economist and manager of New Delhi's Oxus Fund. Singh "will take India to the next level."

That is the hope. But the new course India is charting also is fraught with peril for this complex nation of 1 billion and for the global economy. The election shock was a stark reminder that the other India -- the India of poverty and neglect -- can still speak with a mighty voice. The masses are making their presence felt just as India is hitting its stride as the world's new megamarket. The economy surged 8% last year, and lately has been expanding at a sizzling 10% clip. India's $15 billion information-technology services sector has exploded, and huge Indian design, research, and back-office service centers are now vital to global operations of multinationals from Intel (INTC ) and General Electric (GE ) to HSBC (HBC ). Foreign investment also has begun to pour into Indian equities, manufacturing, and tech startups.

The government's challenge will be to keep the boom going -- while at the same time delivering on its social promises to an often desperate electorate. India spends just 6% of gross domestic product on social services like education and health care, and most economists agree Congress should at least double that. To ease major bottlenecks to industry, India also must step up investment to modernize the nation's dilapidated roads, electricity distribution, ports, and airports, a job started by the BJP.

Congress says it has a strategy for boosting growth and social spending without jacking up taxes. "We have worked on economic policy assiduously for the last five years," says Salman Khurshid, a senior party member. "We have the formula for 8% to 10% growth that will give us the jobs we need and growth in agriculture. It can't come from heavy taxation."

Khurshid talks about boosting the savings rate, cutting wasteful spending, and encouraging private investment, but the party has been very vague about where the extra billions will come from. The obstacles are daunting. India's public finances are precarious, both at the central and state levels, with an alarmingly high fiscal deficit of 10% of GDP. So Singh must find a way to pay for new programs without steep tax hikes that will kill new investment. Even if he can mobilize funds for more schools, roads, water projects, and clinics, programs must be efficiently implemented -- a hard task given the country's dysfunctional, corrupt bureaucracy.

Congress' job also will be complicated by its fragile coalition in Parliament. Congress and about a dozen allies have a majority in Parliament. But Congress itself has only 145 of 539 seats. So it may have to appease the communists, key allies that control 53 seats. That could force Singh to slow or halt further sell-offs of state assets in sectors like energy and food distribution. Such moves could deprive the government of badly needed revenues, curtail growth, and dampen new private investment. It was Communist Party General Secretary AB Bardhan who helped spark the post-election crash by declaring, "Let privatization go to hell." Singh vows to press ahead with privatization, but a full-blown revolt could bring down the government. Leftists also oppose reform of labor laws that stifle new manufacturing investment by making it hard to hire and fire as needed.

While some slowdown in reform is to be expected, the question is whether Singh and his team will be able to craft a credible agenda and sell it to the coalition in time to keep the economy from losing momentum. It's unlikely that even a bad government would derail the IT sector, which has grown with little public spending. Indian governments always have done a lousy job of providing basic infrastructure, notes Chief Executive Vivek Paul of IT-service giant Wipro Ltd. (WIT ), whose customers include Microsoft Corp. (MSFT ) and Delta Air Lines Inc. (DAL ) Most software firms and call centers have their own power generators, water supplies, and high-speed telecom links. When nuclear tensions flared between India and Pakistan in June, 2002, many U.S. clients voiced worries. But clients so far have been sanguine about the election. "My phone lines were quiet," Paul says.

Unfair Subsidies

If Congress can deliver on its mandate, the long-term payoff could be tremendous. There's little dispute that India can't develop into a modern economy while 300 million people subsist on less than $1 a day. The middle and upper classes thrived as growth averaged 6.2% annually in the 1990s. But far from the marble-and-glass research and office parks in Bangalore, Bombay, Hyderabad, and Delhi, 65% of Indians live on agriculture, a sector that has stagnated. Nearly 40% of Indians remain illiterate. Miserly government spending and poor management of rural roads, electrification, irrigation, health care, basic education, and sanitation have left most of this population behind. Indeed, through the hot growth years, the gaps between rich and poor and between urban and rural areas grew dramatically wider.

Given such unbalanced growth, many experts say it would have been difficult for India to sustain its success without a dramatic change in policy. Nor could it clock 9% to 10% growth year after year à la China, which laid the groundwork for development decades ago by emphasizing agricultural reform and primary education. Unemployment in India is estimated at 7% to 10%, and with 10 million entering the workforce each year, joblessness will worsen. Economic growth must accelerate, because its current pace is "just not good enough to sustain a country with per-capita income of $500 and a population growing 1.9% a year," says Ruchir Sharma, managing director of emerging markets at Morgan Stanley Investment Management.

The BJP had promised to make rural development its new priority after the elections. But Congress actively courted the poor -- who made their voice heard. Many of India's top technology tycoons agree the poor's needs must be met if support for liberalization and foreign investment is to continue. "We cannot only have IT-related development," says Infosys Technologies (INFY ) CEO Nandan M. Nilekani. "We have to extend the success across industries from agriculture to manufacturing."

There is wide agreement on what the government must do. Start with agriculture, which has grown just 2% annually in the 1990s -- about the same rate as India's population -- and now accounts for just one-quarter of GDP. Only 7% of India's $125 billion in annual public and private investment goes to agriculture. Some 223 million Indians live in hunger, more than in all of Africa, consuming less than 1,960 calories per day, according to the U.N. Development Programme (UNDP). This is despite the fact that India's green revolution has made it more than self-sufficient in rice, wheat, and milk.

What gives? For one, the government's farm subsidies lead more to market distortions than higher incomes. Big, politically connected farmers get half of the free fertilizer, water, and power the government hands out, as well as minimum guaranteed prices for certain crops. As a result, farmers often use too much fertilizer and cultivate water-intensive crops, even in drought-prone states like Maharashtra in the West and Andhra Pradesh in the South. These practices have depleted the water table in much of India, says Arun Kumar, chairman of the Center for Economic Studies & Planning in New Delhi.

About 75% of cultivated land, meanwhile, has no irrigation at all, increasing dependence on the monsoon. A long drought from 1999 to 2002 forced hundreds of farmers in Karnataka and Andhra Pradesh -- states that ironically have the biggest tech industries -- to lose their farms and become day laborers. Few farmers can afford to invest in irrigation, power generators, or new technologies to boost yields. The poor allocation of resources largely explains why China, with 60% of India's cultivable land area, produces 40% more food. The lack of infrastructure, meanwhile, partly explains why India lacks a food-processing industry, which could create badly needed jobs in the countryside. A 2003 McKinsey & Co. report says food processing could be a $50 billion annual industry for India by 2008 if the government improved roads and storage facilities and lured private investment.

But just throwing more money at such problems isn't enough. Good intentions often break down at the local level. "It all boils down to poor governance," says chief economist Subir Gokarn of Indian rating agency Crisil. "The government machinery in rural India is woefully inadequate."

The machinery also is failing Indians in education. That may sound unusual to anyone familiar with India's astounding success in technology and skilled services. The problem certainly isn't in higher education, where the government devotes disproportionate resources compared with primary education. India produces nearly 300,000 engineers annually, and 2.5 million college graduates from 253 universities and 13,150 colleges.

The real problem is with primary education. When they were at the same stage of development as India is now, Asian tigers like South Korea, Taiwan, and China focused on elementary and secondary schools. As a result, they achieved nearly universal literacy among youth -- the educated workforce that fueled economic takeoffs. But until a decade ago, India spent less than one-third of its education funds on grades one through eight, and still spends less than 4% of GDP on education. That's a big reason India's literacy rate of 62% lags behind China's 85%. "You don't get sustained high economic growth rates unless you have the human capital upon which to build them," says UNDP economist Santosh Mehrotra. What's more, 97% of education spending goes to teacher salaries. "That leaves little left over for anything else."

New Talent

India does have plenty of schools -- 900,000 of them. It also boasts 3.8 million teachers. But dropout rates are high because of high absenteeism by teachers and a curriculum that revolves around rote learning. "India has made improvements in the quantity of education," says Wipro Chairman Azim Premji. "Now, we must focus on quality and get the private sector to contribute more." Premji funds his own foundation to modernize curricula and attract dropouts back to school. What's needed, he says, is for government to increase accountability of schools and administrators.

Last year the BJP government passed legislation to provide girls free tuition up to the age of 15 to lure more into the schools. Congress promises to double education spending. For now, though, most Indians even in rural areas are eschewing the mismanaged public system and tapping their meager savings to send their children to private schools. Rama Bijapurkar, a marketing strategist who studies social trends, notes that rural Indians have been increasing their spending on education and health care -- another public sector that's badly run -- by 20% a year. "This provides an escape from poverty for their children," Bijapurkar says.

Before India can make serious headway in resolving its deep social problems, Congress must get public finances in order, and push the reforms past special interests, apathetic bureaucrats, and dissident lawmakers. If anyone can solve the budget conundrum, it could be Singh. When he became Finance Minister in 1991, India was in a full-blown balance-of-payments crisis. He devalued the rupee, began to liberalize strict controls on industrial investment, lowered import tariffs, and opened numerous industries to competition. In the process, he whittled down India's massive budget deficits and foreign debts.

Whipping India's political system into line will be harder. But Gandhi, who will remain Congress' dominant figure, has shown management acumen in her six years as party president. In the 12 states where Congress rules, she demanded balance sheets and report cards to assess the performances of each state minister. And Congress has recruited new talent such as Milind Deora, 27, a business graduate elected to Parliament from Bombay. Deora says he'll spend part of his constituency's $444,000 budget on a computer project in the poorest schools. "We want to fill the gaps that existed under the old guard," he says.

On the national stage, Gandhi will have to learn the art of compromise and collaboration with rowdy coalition partners and opponents. She would do well to reach out to the communists, who have done remarkably well in spreading literacy and land reform in the two states they rule, Kerala and Bengal. Farm output in those two states has risen an average 6% annually, twice the national average, for two decades. The communists in Bengal and Kerala also have proved surprisingly open to foreign investment, promoting IT, and persuading unions to curtail strikes. Gandhi's decision to forego the top post could head off another serious obstacle to passing legislation -- a hostile BJP. The BJP initiated many vital reforms and some legislators promise to vote for Congress proposals they agree with.

Lest Congress revert to its old ways, however, it should have learned at least one thing from the elections: Its popular mandate will last only if it meets the aspirations of the poor. "If the new government does not perform, they'll be rapidly voted out, too," says election analyst Dorab Sopariwala. By dumping stocks in mid-May, investors also put the government on notice: Drift too far to the left, and investors will head for the exits, bringing the glittering mirage of a wealthy new India tumbling back to reality.

Striking the balance between meeting the demands of the markets and the restless poor will be India's toughest challenge since the 1991 financial crisis. But if Gandhi's Congress party can survive the critical first months and keep the economy on track, it could set the stage for the developing world's next dramatic economic takeoff.

By Manjeet Kripalani

With Pete Engardio in New York

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