How can India become an economic powerhouse after years of state control?

India drifts at the edge of Australian perception, surfacing now and then in the headlines as a country enduring dreadful poverty, tearing itself apart with religious killings, or tottering on the edge of nuclear destruction. These images form what many observers see as India, and to a point, hold true.

But there is something else happening inside this huge, complex country. Market forces are being unleashed on India's economy, sweeping aside decades of socialist-inspired economic planning. In this new age of free markets, how is India coping with capitalism?

During the post-war decades, India offered the world a distinct path to development: self-reliance, central planning, and government ownership of industry, wrapped up in an ideology of democratic socialism. At a time when the Iron Curtain divided most of the rich world, and when autocratic regimes ruled many developing countries, India boasted a multiparty democracy.

Yet India's economy was a jungle of government controls. After booting out the British Raj, India quickly erected its own "Permit Raj" where bureaucrats stamped almost every step of production in a Byzantine system of industrial licences and permits.

Revered former Indian Prime Minister Jawaharlal Nehru summarised the logic of this system: it was better to make a second-rate Indian product, Nehru reasoned, than to import a foreign good. Perhaps the best example of this dictum is India's 'Ambassador' motorcar. The 'Amby' was first built in 1948, one year after Japan's Toyota rolled out its first car. While Toyota has since carved-up world markets, India still produces the Amby with its original retro design largely intact.

Why? The main reason is that, for some 30 years, the Amby enjoyed a government-approved monopoly. The Amby's private-sector manufacturers were enriched and, protected from competition, faced little pressure to innovate. The same cosiness applied to Indian industry at large. Thus coddled, Indian big business was protected from the cold discipline of free-market competition. The worst outcome was that the system delivered state subsidies, usually to the better off, instead of delivering quality education and public health for the masses.

On an economy-wide scale, India's socialist system delivered what its critics labelled the "Hindu rate of growth" of 3.5 per cent a year compared with south-east Asian growth rates of 8 to 15 per cent. Economic growth lagged population growth, and by the late 1970s poverty was worse than ever.

By 1991 the system delivered an economic crisis. India's foreign exchange pool had evaporated, with just enough money to cover a fortnight's imports. Facing financial ruin, the government had to sell part of its gold reserves as collateral for an emergency International Monetary Fund loan. India's economic experiment had failed. The crisis forced emergency surgery. India's government unravelled the complex licensing system, lowered import restrictions, devalued the rupee (making Indian exports cheaper) and prised open India's financial system to competition. In short, India embraced the market.

Twelve years later, there is no doubt that India's economic reforms have now created a new consumer middle class. In most of India's cities there are trendy coffee shops, international restaurants, and multiplex cinemas cashing in on the disposable incomes of urban consumers. But now that India is merging into the global economy, what is happening to Indian society?

One original voice responding to this question is Gurcharan Das. Das is a former Procter & Gamble boss who made an early splash in India when he re-branded Vicks Vaporub as a traditional medicine and boosted sales by inventing a new ailment, "wet monsoon colds". Das left business to write and venture into management consulting.

His latest book, The Elephant Paradigm: India Wrestles With Change, describes modern India through a series of essays crafted around events, personalities and issues. Das is a devout believer in free markets but writes that he is "at heart an old-fashioned liberal" (in the American sense) bent by a profound distrust of state power. His central charge is that Indian socialism tried to create a compassionate society but in the process strangled capitalism's capacity to innovate and create wealth.

Now that India is lurching forward on a pro-market economic program, Das says problems will come in controlling capitalism's inequality. He concedes that capitalism is merciless to weak producers and uncompassionate to jobless workers but he believes in the free market's efficiency trade-off, saying competition forces costs and prices to come down and improves product quality and thus living standards.

But as Western experience shows, the market's other face is commercialism. Das observes that when affluence grows, people are freed from basic wants and appear to get bored and suffer from spiritual disquiet. "[Capitalism] also leads to a greedy consumer society where people care only about their interest and, after losing faith in religion or idealistic ideologies, are left with little to do except go shopping," he writes. Das believes, however, that India's powerful family bonds and religious values will help Indians absorb the shock of the market.

Yet religion arguably poses the greatest threat to India's society. Virulent Hindu fundamentalism is poisoning Indian politics. It is a blight on India's economic modernisation that the state of Gujarat, among the best performing in terms of economic growth and rising incomes per person, was also the state where Hindu mobs last year butchered some 2,000 Muslims. It was the worst outbreak of communal violence since millions were killed during India's separation at birth from Pakistan.

Das points out that Hindu nationalism is indeed one response to India's globalisation. In the eyes of the nationalists, India was a victim of thousands of years of foreign invasions, and multinational corporations and American culture are now threatening it. What they want is to "restore" India to its pure Hindu past, then advance to become a Hindu superpower in the future. India's atomic bomb is part of the plan.

Das says communal peace will not come from converting India into a secular, non-religious version of the West but from the efforts of moderate religious leaders. Until these voices step forward, Das laments that Indians will have to live in an age of extremism.