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India's Coming Eclipse of China
Wall Street Journal
March 2006
By Hugo Restall
Mr. Restall is the editor of the REVIEW.
Economic comparisons of India and China inevitably
start with the two nation's 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, "The 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 enterprisesâresearch 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 incomesâat 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 farmer-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.
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