The Microeconomic Rise of India
By Yasheng Huang

According to the World Economic Forum’s “Global Competitiveness Report (GCR) 2005-06,” released last September, China ranks 46th on the “Growth Competitiveness Index” and India 55th.

It’s a pity that the GCR is often cited but seldom read. Beyond the table on overall rankings of country competitiveness, the report contains a wealth of valuable information and insights. In particular, a measure designed to capture the microeconomic foundation of economic growth, the business competitiveness index (BCI), adds significantly to the China-India comparison debate.

China dominates India on almost every macroeconomic indicator. In the 2003-04 GCR, China was ranked at 25th place on the macroeconomic environment index, compared with India’s 52nd place. Newspaper headlines reveal the same story: China has had a faster GDP growth, and its per capita income is twice that of India. China’s exports have been growing faster and are substantially larger in terms of volume. It produces more steel, builds more roads, highways and skyscrapers faster than Indians can build slums. For foreign analysts, the most favored measure of economic success is the level of foreign direct investment (FDI). And almost every comparison of China and India will tell you that China attracts 10 times the amount of FDI as India.

Looking at microeconomic indicators, however, a far more complicated picture emerges. In 2004, India ranked 30th in the BCI, far ahead of China’s 47th place ranking. On other components of microeconomic competitiveness—company operations and strategy, and quality of the national business environment—the Indians (30th and 32nd) were similarly ahead of the Chinese (39th and 47th). Yet perhaps the most stunning revelation is that since 1998—the first year this microeconomic ranking was produced—China’s standing has declined, whereas India’s has improved substantially.

Despite a sharp increase in FDI amidst a growth rate of nearly 10% a year, China’s microeconomic foundations for growth since joining the WTO have deteriorated. India, in contrast, has quietly and solidly improved its microeconomic competitiveness. In terms of BCI, China was ahead of India by two places in 1998; in 2004, it was behind India by a yawning gap of 17 places.

The most important thing to note in any China-India comparison is that there is a substantial difference between the macroeconomic measures and microeconomic measures of these two countries. China’s GDP growth is faster, as widely acknowledged, but its corporate performance has been very poor. The index of Shanghai Stock Exchange has declined by 50% since 2001. Based on Standard & Poor’s Compustat data for 346 top-listed companies in both countries, BusinessWeek calculated that the average Indian firm posted a 16.7% return on capital in 2004 versus 12.8% in China. This performance gap between Indian and Chinese firms has long persisted. According to a UBS report, during the 1998-2003 period, the average return on capital employed (ROCE) for an Indian firm was about 17%. For Chinese firms the figure was only 11%. If anything, these numbers may overstate Chinese performance. Many of the performance indicators do not take into account the fact that the cost of capital is heavily subsidized for state-owned firms in China. BusinessWeek quotes Chen Xiaoyue, president of Beijing National Accounting Institute, as saying that two-thirds of 1,300 listed Chinese firms fail to earn back their true cost of capital. This implies that return on capital might have been negative if capital were appropriately priced in China.

This growing gap between macroeconomic and microeconomic performances has several serious implications. That India came from behind China provides the single best proof that India’s achievements are due to its longer history of capitalism. The fact is that China was significantly ahead of India in economic liberalization in the 1980s and for the first half of the 1990s. My view is that economic reforms began to stall in China since the late 1990s, but in India they have continually moved forward, however gingerly.

The performance gap also raises some serious questions about the state of the Chinese economy. As Michael Porter of Harvard Business School, author of the microeconomic competitiveness study, pointed out: “Wealth is actually created in the microeconomic foundations of the economy.” GDP is an output measure, and the idea of economic growth is not so much to increase output but to create wealth. That the Chinese firms are making lower—and potentially negative—returns on their investments suggests that value is not being created. Indeed, there is now evidence that the Chinese economy is less impressive in wealth creation compared to the Indian economy. The World Bank has just released a report that provides some measurements on wealth creation (based on 2000 data). China’s per capita income is about twice that of India, but by wealth measures, China is only 37.6% wealthier than India. China looks especially poor in the area of intangible capital—which is a function of education, rule of law and other intangible characteristics of an economic system. China has an intangible capital of $4,208 per capita as compared with India’s $3,738.

Journalist Simon Long duly noted in a survey article in the Economist that China produced more, but India was more efficient in the long-run. Yet his conclusion seemed to proclaim: “But who cares?” This obsession with output measures—apparently shared by Brezhnev and Western observers alike—is extremely damaging. For one thing, this obsession overstates Chinese achievements and understates those of India. The outputs China produces are visible, especially in the form of skyscrapers in metropolises, but to appreciate Indian strengths one has to interact with Indian entrepreneurs and managers in order to understand their impressive visions and capabilities.

Output obsession has also led to a wrong policy model. The idea that building skyscrapers, airports, highways and power stations is equivalent to economic growth has done the biggest damage to China’s microeconomic competitiveness. In China, this idea has led to massive and forcible seizures of land, the destruction of perfectly functional housing structures and a reduction of arable lands. These actions are terribly destructive in their economic effects, one of which is that the sense of property rights security—so fragilely maintained since the end of the Cultural Revolution—is undermined. The damage is especially extensive in rural China. My own research shows that rural entrepreneurship flourished in some of the poorest regions of China in the 1980s, but in the 1990s, financing became more difficult and, according to Chinese education researchers, rural basic education suffered.

A country cannot stray from its microeconomic fundamentals forever. At some point, China’s macroeconomic performance will have to converge to a level compatible with its microeconomic conditions. Growth will slow down unless the Chinese leadership begins to proactively correct the deep institutional distortions in the Chinese economy by immediately banning all forcible land grabs and creating market-based land transactions, launching privatization programs, drastically improving both political and corporate governance and accountability, and opening up China’s financial sector to both domestic and foreign competition. Given China’s deep advantages in basic education, its formidable technical and scientific prowess, and its long and successful tradition of entrepreneurship, there is not a single good reason why China should lag behind India on microeconomic competitiveness.

Mr. Huang is an associate professor in international management at the MIT Sloan School of Management and the author of Selling China (Cambridge, 2003). He is working on a book about the domestic private sector in China, entitled Capitalism with Chinese Characteristics.
Posted by: john 2006-03-11