India’s Coming Eclipse of China
By Hugo Restall

Economic comparisons of India and China inevitably start with the two nations’ obvious strengths. India punches above its weight in the service sector, particularly information technology and it-enabled services. China is the undisputed leader in attracting foreign direct investment, and it is remarkably open to trade for a large developing country, with imports and exports accounting for more than 50% of GDP. With these starting points, both countries appear to have bright futures.

But in fact their strengths are symptoms of underlying weaknesses. Indian capital and talent is drawn to the IT sector largely because it is one of the few new fields which has not yet been stifled by government regulation. Service companies, especially in fields that export their product over a fiber-optic line, also stand out because they are less vulnerable to the country’s infrastructure bottlenecks.

Likewise, China’s dependence on FDI stems from the weakness of the country’s banks and capital markets. With a savings rate of more than 40% of GDP, there is plenty of capital around, but few domestic institutions to allocate it efficiently. Moreover, high trade figures are symptomatic of a shortage of innovative companies able to create new products and build global brands. So far, China is stuck as the world’s low-cost workshop, importing components, snapping them together and shipping them out again, adding little value.

This analysis means that it would be foolish to extrapolate the future of these two giants from the consensus view of their strengths. Rather, both are going to change dramatically as they address these weaknesses. That will take them in new directions with new growth trajectories.

Today India and China are racing at breakneck speed, with as little as one percentage point difference in their growth rates, and in theory they could sustain this pace for decades. Because China embarked on its economic reform program 13 years before India, it currently enjoys a healthy lead in per capita GDP. But India’s challenges are more conventional for a developing country, and more easily addressed. China, by contrast, faces several perilous transitions which will slow its growth. As a result, India is set to steal the spotlight as leader of the developing world.

Miracle or Mirage

Let’s stipulate that China is not willfully fooling the world with outrageously inflated statistics as it did during Mao Zedong’s time. But some part of its latest economic “miracle” will also turn out to be a mirage. This growth is driven by levels of savings and investment the world has never seen in a market economy. Even though China has largely abandoned state planning, it still resembles Stalinist Russia in this one respect: Mobilization of capital, labor and raw materials provides the bulk of its growth, not productivity gains.

In fact, given the amount of investment, the biggest surprise of China’s growth is how slow it remains. As a recent World Bank study said, “[T]he growth outcome, while high in comparison with other countries, is not commensurate with the input of resources.” During their high growth phases, both Japan and Korea grew faster than China today, with a lower level of investment.

All this makes many economists nervous about the quality and sustainability of China’s growth. Before the 1997 Asian financial crisis, East Asia’s fastest growing economies were dependent on this kind of mobilization of resources rather than productivity growth. The result was that when faced with overcapacity, companies could not make the profits necessary to service the debts they had incurred in order to build their factories.

China’s squandering of capital will have long-term consequences. While some believe that future growth in demand will take care of overcapacity problems, it is more likely that Chinese companies will have to export their way out of trouble. Given that trade tensions with the U.S. and Europe are already running high, this sets the stage for a crisis in the global trading system.

Moreover, the banking system’s nonperforming loans are officially estimated at about 25% of total loans, but most experts put the real figure at around 40%. At that level, they are bankrupt. Because of the high savings rate, new deposits continue to flow in, keeping the banks liquid and allowing them to go on lending. But when the flow of savings slows, as it must some day, the government will have to recapitalize the banks and add their losses to the national debt. At current levels that is still manageable, but for how much longer nobody knows. Occasionally there are small bank runs in China, but so far the government has been able to maintain confidence by standing behind the banks.

China’s incremental capital-output ratio, a measure of the amount of investment needed to create a given amount of GDP, is high and rising. According to the World Bank, the ratio has steadily risen to 5.4 in 2002 from 3.96 in the first half of the 1980s. The crisis in 1997 was preceded by a similar phenomenon in East Asian countries.

The FDI Champion

Much attention is paid to the fact that China pulled in some $60 billion of FDI last year, while India attracted an estimated $5 billion. In part this is due to measurement problems. If India used the standard definition of the International Monetary Fund, its FDI figure would be closer to $10 billion. And a large portion of China’s FDI, perhaps one-third, is really domestic capital leaving and then re-entering the country, so-called “round-tripping,” in order to receive the preferential treatment given to foreign-invested enterprises.

Even so, China remains a bigger destination for investments by multinational companies. But is this a sign of strength or weakness? Many argue the latter.

Despite its abundant savings, China’s most dynamic companies often struggle to get funding. That’s because the banking system is almost entirely state-owned, and the banks are reluctant to lend to private companies. As Yasheng Huang and others have written, entrepreneurs access finance by partnering with foreign companies. The more entrepreneurial state companies which want to escape government interference also sell stakes to foreign firms. Since foreign-invested firms get all sorts of preferential treatment compared to locals, such as tax holidays and exemption from troublesome regulations, the incentive is all the greater to find a foreign partner.

Why does China treat foreign businessmen better than its own people? One answer is politics. The Communist Party is afraid of nurturing a class of local entrepreneurs which could form an independent power base. It is more comfortable with foreigners, especially overseas Chinese, because they generally have no interest in challenging the power of the party.

This explains why the foreign-invested sector of China’s economy accounts for most of its productivity gains and about half of its exports. These companies have brought in management and production techniques perfected elsewhere and combined them with cheap Chinese labor. But there is little local innovation in such enterprises—research and development, design, branding and other such high value-added activities have up until now been kept in the headquarters abroad.

Truly private businesses have contributed to China’s growth, but they have to keep a low profile. The typical entrepreneur raises his start-up capital from friends, family and underground banking institutions. He reinvests his profits, and when his business reaches a moderate size, he stops growing that enterprise and uses his profits to start from scratch in other industries, creating a mini-conglomerate. Therefore private enterprises, while very entrepreneurial, never have a chance to achieve real efficiency through economies of scale and concentration on a core business.

So what Chinese companies do get loans from the banks? Mostly state-owned enterprises, which are protected by officials at various levels of government. They account for only 25% of output, yet they receive 65% of lending.

True, state companies are not as hopeless as a decade ago. Between 1998 and 2003, the government undertook massive lay-offs of 50 million workers, or more than one-third of the state-sector workforce. It also sold off most of the small- and medium-sized SOEs. Today we are told that the remaining large SOEs are profitable on the whole.

But there is good reason to be skeptical. “Reforming” SOEs without changing ownership makes little difference in their performance. We know that these companies do not face a hard budget constraint, meaning it is possible for them to use new borrowing to cover up past losses.

Incredibly, Beijing harbors dreams of creating state-owned conglomerates that will become world-class like Japan’s keiretsu or Korea’s chaebol. Conveniently ignored is the fact that these companies, while receiving much government support, remained private. While it dithers over privatization, vested interests that will resist future reforms are becoming more entrenched.

Together these phenomena explain why there is so little total factor productivity growth in China, so little innovation. China is not developing world-famous brands because its big companies are not nimble or savvy enough. By handicapping its own entrepreneurs, China has so far largely confined itself to being an assembly center for the world’s multinationals.

India Shining

India’s approach has been almost exactly the opposite of China’s—it nurtured its own entrepreneurs and held multinationals at arm’s length. Its largest private firms are about 10 times the size of China’s. The problem was that they were sheltered behind a high wall of protectionism until a decade ago, so they didn’t have to compete with world-class companies. In a hangover from colonialism, Indians worried that if multinationals were allowed in, they would exploit Indian workers and consumers, strip the country of profits, and drive local companies out of business.

That attitude is largely history, although vestiges persist. India’s trade barriers are still high, with peak tariff levels at 20%, compared to China’s 10.4% and a developing country average of 13.4%. Nevertheless, it has been gradually opening and finding that its companies not only cope with competition, they thrive. Success in the IT sector has been the catalyst, showing Indians that they can be world-beaters.

India has a huge advantage in its financial institutions and capital markets. Its banks are largely privately owned, and while their levels of nonperforming loans are relatively high at around 15%, they conduct credit risk analysis on their borrowers and are run along commercial lines, in contrast to China. India also has a functioning stock market.

As a result, Indian companies use capital more efficiently. The country’s incremental capital-output ratio is generally lower than China’s, and in recent years it has actually been falling. As is normal for a developing country, its savings rate, currently around 25% of GDP, is not sufficient to finance its investment. This reflected in higher interest rates: India’s prime lending rate is consistently over 12%, compared to 8% in China. But now the vast pool of global capital is discovering India. The country is set to reap the benefits of higher levels of investment as FDI and portfolio investment increases in the coming years.

That will be combined with a huge wave of new and trainable workers. Demographically, India is a young country, with more than 40% of the population under the age of 20—that’s 450 million people, as compared to 400 million in China. More important than their ability to work is their ability to think: The generational divide in India is pronounced, with the young by and large uninterested in the zero-sum socialist ideas of their elders. It’s also revealing that they are pursuing advanced education with a zeal that was formerly thought of as a Confucian trait—American universities enroll 80,000 Indian students, compared to 62,000 Chinese.

Finally, India is attractive to multinationals because it has a commitment to the rule of law and protecting intellectual property. Not that either is always well implemented, but the contrast with China, headquarters of the world’s IP pirates, is striking. This explains why India has home-grown, innovative companies, and is becoming a base for multinationals to conduct research in high-tech fields. Many came initially to arbitrage lower wages on routine work, but are now pressing into cutting edge fields.

Even the notion that business gets done more quickly in China needs to be re-examined. Narayana Murthy, founder of Infosys, was shocked it took months just to conclude a land agreement for a 15,000-employee facility in Hangzhou. Of Chinese officials, he complains, “Sometimes you can get confusing signals.” Getting money out of Chinese clients is not easy either; Infosys gets paid in 56 days on average in India, but in China it must wait 120 days.

Politics in Command

To China’s credit, it is addressing many of its problems. But here is where the contrast between Indian democracy and Chinese authoritarianism really comes into play. China has done well by picking the low-hanging fruit, the easy reforms in which there were many winners and few losers. For instance, by freeing farmers to produce their own crops 25 years ago, rural incomes rose and the supply of food in the city improved. Allowing prices to fluctuate with supply and demand corrected gross misallocations of resources. But more recently reforms have required difficult choices, such as laying off state workers.

So far, Beijing has continued to press ahead. But it is facing a rising tide of discontent, with about 75,000 public demonstrations a year. The benefit of authoritarianism was supposedly that China could make decisions for the greater good without being stymied by the objections of a minority. Yet it is becoming increasingly unclear whether the Chinese government can retain the consent of its people.

China’s embrace of globalization was never built on a solid foundation, and thus a public backlash against the government could bring the whole edifice down. Andy Xie, Morgan Stanley’s chief Asian economist, recently released a report entitled “Time to Change,” which concluded: “Rising internal tension over inequality and external friction over China’s trade success suggest that China’s government-led and export/investment-driven development model may be reaching its limits.”

Meanwhile, India’s politics are as tumultuous as ever, but the caravan of reform moves on, regardless of changes of government. That’s because under its strong democracy, India has worked through dissent rather than sweeping it under the carpet. Now the country is finally getting a fillip from the phenomenon that has kept China afloat all these years: When a rising tide is lifting most boats, disputes over necessary reforms become less acrimonious. At or above the current level of 8% growth, some believe, India is able to pursue reform and use its increased revenues to compensate sectors of the population who are temporarily left behind.

So can India learn anything from China? Certainly China has done better at providing necessary infrastructure, but that is already well understood. More critical is the problem of excessive labor regulations, which China eliminated first in special economic zones and then nationwide. In Chennai, the editor-in-chief of the Hindu, N. Ram, borrows the old Chinese term “iron rice bowl” to describe jobs at his newspaper—nobody can be fired, no matter how little work they do. “It’s better than a government job,” he says.

This especially hurts India’s ability to attract investment in manufacturing. And it is manufacturing, not services, that can provide employment for the hundreds of millions of low-skilled farmers who will leave the land. This is also the key to raising productivity and incomes—at present, the roughly 60% of the population engaged in agriculture produces just 22% of GDP output is growing at less than 2%.

Yet so far, parliamentarians are reacting to a spate of farmers’ suicides by approving money for make-work schemes in the countryside, instead of clearing the way for a manufacturing boom that could offer life-saving opportunity. Changes in labor regulations are the No. 1 policy change that could unlock faster growth.

A close second is opening up the retail sector fully to foreign competition, and here again India could learn from its neighbor. By allowing in firms like Wal-Mart and Carrefour, China has benefited consumers, stimulated demand, helped to develop a host of other industries and fostered the creation of distribution networks. Until now, both moves have been blocked by left-wing parties in the ruling coalition.

Nevertheless, the incremental steps being made show that these changes are within reach. For more than a decade, China has been the darling of the global business community, which fawns over its “miraculous” growth. Now India is poised not only to shine, but even to eclipse China.

Mr. Restall is the editor of the Far Eastern Economic Review.

Posted by: john 2006-03-11