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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

#15  I am pretty inept along the axes of things financial or business. Yet even I have heard of Acer, LG and BASF. I don't know if that helps any of you who actually understand the arguments in this thread. ;-)
Posted by: trailing wife   2006-03-11 23:42  

#14  NS: TSMC. UMI. Ever heard of them? Is BASF a well known brand in America? Daewoo is probably better known. ZF's one point that is well taken is that both these countries performance will be determined by domestic constraints more than anything else.

Apples and oranges. Everybody's heard of BMW, Mercedes, Porsche, Volkwagen and Audi. Hyundai is an also-ran - Daewoo isn't even an also-ran. Dow Chemicals is a lot like BASF, but nobody's heard of a lot of its brand names.

Besides, this is getting silly. Comparing the East Asian tigers to China and India is like comparing a guy in a bespoke suit to hoboes in rags. Korean autoworkers make $10 an hour. Chinese autoworkers make $2 an hour. Chinese wages can grow 10% a year for decades and never match the Korean ones. China and India are decades behind the East Asian tigers. And they will remain far behind for next few decades. The question here is whether China's rags will be better-looking than India's rags. Based on current Indian economic policies, I have little doubt that this will continue to be the case.
Posted by: Zhang Fei   2006-03-11 23:16  

#13  NS: Interesting forecast of 17 largest economies in 2050 and winners and losers in that economy.

Interesting survey. Kind of weird, in the sense that it projects higher per capita GDP growth rates for India than China over 45 years, yet comes out with a higher 2050 total GDP for China, in spite of the fact that China has a smaller population than India. What I found weird was its projection of 2.4% GDP growth for the US. I think we'll do better than that. Much better.

Nonetheless, these projections are like the weather forecast - partly in the sense that they are garbage - and partly in the sense that they rely on too many political and technological changes that are unknowable at this stage. Besides, if auditors can't even report the past accurately (re Enron), how can they predict the future?
Posted by: Zhang Fei   2006-03-11 21:54  

#12  Acer doesn't have a brand name - it has manufacturing facilities.

Boy, you don't read the computer magazines I read. Acer is a brand name in it's own right. It has been for a good while now. Lots of multipage full color glossy ads.

Here are a few recent reviews of Acer-brand notebooks from PC Magazine. Not exactly an advanced technology / specialist journal - it's pretty much aimed mostly at consumers.
Posted by: lotp   2006-03-11 21:44  

#11  Interesting forecast of 17 largest economies in 2050 and winners and losers in that economy.
Posted by: Nimble Spemble   2006-03-11 21:36  

#10  lotp: ZF, this is silly. For Taiwan brands, you ignore companies like Acer, which just displaced Toshiba as the 3rd largest seller of laptop computers in the world. No well-known Taiwanese brands, my foot. Note that, unlike the Chinese purchase of IBM's line, Acer's is engineered by THEM. Human capital matters. China has potential, but it also has many many potential pitfalls going forward.

Acer sells the vast majority of these laptops under somebody else's label. Acer doesn't have a brand name - it has manufacturing facilities.

I think there is a strange underlying assumption here. And this assumption is that China and India are going to catch up to the United States. That is the underlying premise for the assumption that China and India should have well-established brands overseas. The fact of the matter is that China and India have a glide-path towards catching up with Thailand. The brutal reality is that they will probably never catch up to Malaysia, let alone South Korea. China and India should not even be mentioned in the same breath as these United States. China will outpace India. It will not outpace Thailand. And India will never catch up to Thailand.
Posted by: Zhang Fei   2006-03-11 21:23  

#9  TSMC. UMI.

Ever heard of them?

Is BASF a well known brand in America?

Daewoo is probably better known.

ZF's one point that is well taken is that both these countries performance will be determined by domestic constraints more than anything else.
Posted by: Nimble Spemble   2006-03-11 21:22  

#8  ZF, this is silly. For Taiwan brands, you ignore companies like Acer, which just displaced Toshiba as the 3rd largest brand of notebook computers in the world:

Acer has unseated Toshiba as the world's No. 3 notebook brand in Q4 2005, with 66.7% year-on-year growth -- highest among the top-five notebook vendors, according to preliminary data from Gartner Dataquest. Acer notebooks ranked No. 1 in EMEA (Europe, Middle East and Africa), and No. 3 in Asia Pacific with 117.1% growth, the highest among the top-ten vendors.

No well-known Taiwanese brands, my foot.

Note that, unlike the Chinese purchase of IBM's line, Acer's is engineered by THEM. Human capital matters.

China has potential, but it also has many many potential pitfalls going forward.
Posted by: lotp   2006-03-11 21:10  

#7  Phil - you're down under. The typical American has heard of *none* of these brands.
Posted by: Zhang Fei   2006-03-11 21:08  

#6  Food product brands from looking in my kitchen cabinet.

MTR - India
Valcom - Thailand
Yeos - Singapore

And note these are products I buy because of the brand.

Asian consumer brands that spring to mind.

Singapore Airlines
HSBC (even though its now headquartered in the UK)
LG (very big here in Oz)

Although, I can't think of a single mainland Chinese brand.
Posted by: phil_b   2006-03-11 20:58  

#5  Well, in my modest way I am an investor and my money is NOT in China, for good reason. I don't claim to be a market whiz, and lately I've been focused on technical research rather than the markets. But my MBA *is* in finance and operations from a top-10 B-school.

It's true that India's exports are not as far advanced, or as consumer-oriented, as China's. But this issue is not where they are right now -- it's where things are headed. And to this MBA China carries a lot more risk than many seem to think.

BTW, my step-father was Chinese, from Beijing. This isn't an issue of cultural chauvanism, it's a recognition of structural issues in economic, legal and social systems.

And, I'm a bit puzzled by your insistence on brand names as a measure of economic output. The big 5 Korean conglomerates are vertically integrated, but do sell the raw inputs to others (as with, for instance, steel). Your metric is unconvincing to me.

And ... do I really have to list all the other Korean brands sold here in the US? A quick google of several consumer electronics categories brings up more than a few additional Korean brands, if you insist that only consumer goods 'count'.
Posted by: lotp   2006-03-11 20:54  

#4  lotp: We'll have to wait and see how things work out, but it's not at all clear to me that China will out perform India economically over the next generation.

You're entitled to your views, but it's not clear at all to foreign investors (as opposed to India-boosters) that India will outperform China over the next generation.
Posted by: Zhang Fei   2006-03-11 20:42  

#3  lotp: Hyundai, anyone? Samsung? to name only the first two that come to mind.

Those are the *only* two. And one of them is still vaguely thought of as the Korean Yugo. Name me *one* Indian (and any non-Japanese and non-Korean East Asian) brand known to the average consumer. Bottom line is you cannot, and have written several paragraphs showing that you can't.
Posted by: Zhang Fei   2006-03-11 20:40  

#2  Ummmm .... where to start.

Korean brands are quite plentiful and well known. Hyundai, anyone? Samsung? to name only the first two that come to mind.

Electrical engineers are quite familiar with Taiwanese brands for components and board assemblies, among other things. You aren't buying in that market so you may not be aware of Taiwan's large position there or the reputation of various Taiwanese mfgrs.

Singapore? Let's see ... according to the CIA Factbook, their famous financial services sector represents about 1/2 their economy. Their 'brand names' are the names of the world financial services firms, all of whom have major activities in that small country.

Restall is right to point to the relative maturity and transparency of India's financial markets as an important factor in projecting growth there. And while I have personal experience with the arrogance of some in the Brahmin caste, I also have plenty of experience with immigrants from India who have displayed great energy, focus and flexibility in settling here and building small businesses. Some of the most successful are investing profits back in India.

We'll have to wait and see how things work out, but it's not at all clear to me that China will out perform India economically over the next generation.

Posted by: lotp   2006-03-11 20:25  

#1  Hugo Restall is guilty of wishful thinking here. He is basically saying that even though China is far ahead of India in terms of economic growth, India will pull ahead because India's government will make the necessary market-opening changes to India's laws to get this to happen. But these changes haven't happened yet, and it's not clear they ever will.

Inside every Indian isn't an American trying to get out. Indians have a bigger superiority complex than the Chinese - their view is that Indian civilization is so superior that they shouldn't have to appropriate the white man's way of doing things. The Chinese, on the other hand, have a less damaging version of this superiority complex, which simply adopts everything Western, yet continues to claim that the 0.001% of their culture that remains Chinese is responsible for their success.

This openness to Western practices is why a trip to China can be disorienting - a lot of its cities look like brand-spanking new, but more crowded versions of American cities, whereas Indian cities are hard to mistake for anything other than Indian cities. When you go to India, you will see plenty of men and women wearing traditional Indian clothing. You will see no one wearing traditional Chinese clothing in China.

Commentators like Restall don't understand that China is privatizing state-owned companies as fast as it can. The companies still owned by the government are being run as profit-making operations. The reason they haven't been totally privatized is because there are a lot of welfare obligations attached to them - and the government wants these obligations to vanish instead of taking them on as the companies are privatized. But from a political standpoint it would be risky to throw tens of millions of workers off the social safety net provided by their employers. What Restall takes to be political unrest is really fallout from the government gradually privatizing state-owned companies. Those demonstrations are a sign that privatizations are occurring on a gradual but steady basis.

As to why Chinese brands are not busting out into the global marketplace, this is a pretty nutty question. How many Malaysian, Hong Kong, Singaporean, Taiwanese or Korean brands do you know of? And these were the fastest-growing East Asian (and world) economies during the 70's, 80's and the 90's. In fact, how many Indian brands do you know of? Are India's Mittal Steel or Wipro household names in America? Japan is the big megillah - it is the one Asian country whose brands have penetrated markets around the world to the same extent that the big Western countries have. There is only one Japan. China isn't Japan. But if China (or any of the East Asian tigers) isn't going to be the next Japan, India isn't remotely in the running.

This sudden surge of affection for India is, in my view, nuts. India sided with the Japanese war criminals during the Japanese war crimes trials. It sided with the North Koreans and the Chinese during the Korean War. It sided with the Soviets during the Soviet invasion of Afghanistan. India will never become as loyal an ally as even France. The fact is that there are lots of democracies that will not become our friends. India is one. Russia is one. I don't think we should kid ourselves about the value of a good relationship with India - it is at best, a borderline hostile neutral.
Posted by: Zhang Fei   2006-03-11 20:09