China, India and the world economy

CHINA, INDIA AND THE WORLD ECONOMY

Introduction

Among countries with at least 10 million people in 2009, China and India have been growing very rapidly since 1980. The World Bank (2005, Table 4.1) reports that China's GDP grew the fastest at an average rate of 10.3% per year during 1980-90, while India's grew at 5.7%. Of the five countries that grew faster than India during this decade, none did so subsequently during 1990-2003. In the latter period, China's GDP again grew fastest at the rate of 9.6% on an average per year, while India and Malaysia, at 5.9% per year, were the third most rapidly growing countries, with Mozambique at 7.1% being the second. In 2003-04, India's GDP growth rate jumped to 8.5%, fueled by recovery from a severe drought in the pervious year. The estimated growth rate for 2004-05 is 7.5% and the projected rate for 2005-06 is 8.1% (CSO, 2006; RBI, 2006). China's GDP growth rates, based on revised data, were 10.1% and 9.9% respectively in 2004 and 2005 and the projected rate for 2006 is 9.2% (World Bank, 2006, Table 1). Thus both countries continue to grow rapidly.

In terms of absolute level of Gross National Income (GNI) at Purchasing Power Parity (PPP) exchange rates in 2003, China, with $6.4 trillion in GNI, was second largest in the World, second only to the United States at $11 trillion. India with $3 trillion in GNI was fourth after the U.S., China and Japan (3.6 trillion) (World Bank, 2005, Table 8.1). It is likely that in 2005, India replaced Japan as the country with the third largest GNI. IMF (2005, Box 1.4) estimates India's share in global output at PPP exchange rates to have risen from 4.3% in 1990 to 5.8% in 2004, and India's growth during 2003 and 2004 to have accounted for one-fifth of Asian growth and one-tenth of World growth, as compared to China's contribution respectively of 53% and 28%. It should cause no surprise then that the rapid growth of China and India has had significant impact on the World economy, though, not unsurprisingly, to the same extent.

In what follows, Section 2 describes the two basic channels, namely import demand and export supply, through which the growth of a country influences growth of the rest of the world and vice versa. Section 3, the main section of the paper, is on growth of China and India and its influence on the World economy. It begins with indicators of the extent of integration of China and India with global markets for goods and services (Subsection 3.1). Subsection 3.2 focuses on Global GDP Growth and Shares of China and India. Subsection 3.3 is devoted to sources and sustainability of growth using conventional decomposition of growth, in an accounting sense, into its components of factor accumulation (Subsection 3.3.1) and total factor productivity (Subsection 3.3.2). Subsection 3.4 is devoted to foreign capital flows to China and India. Section 4 looks at the place of, and competition between, the two countries in global markets from a disaggregated perspective. Section 5 concludes with some brief remarks on how public policy could influence the emerging growth scenarios and their impacts.

1. Interdependence of Growth Among Trading Nations

It is trivially obvious that if the World consists of autarkic economies, there cannot be any interdependence in growth across countries. Thus, the greater is the integration of an economy with the rest of the World in trade in goods and services, investment and finances, the greater is likely to be interdependence in growth. More specifically:

The sources of demand for the output of any good or service in the home economy are essentially two, namely, domestic and foreign. To the extent foreign demand accounts for a significant share of total demand, clearly growth in foreign income, ceteris paribus, will lead to growth in foreign demand for home exports and hence to growth in home income. This is the export-led growth channel for the domestic economy. A substitution of home exports by domestic supply abroad could be source of growth for the rest of the world. This is the home export substitution abroad (equivalently, foreign import substitution) channel for the foreign economy.

Analogously, the sources of supply for meeting the domestic demand for any good in the home economy are again two, namely, domestic and foreign. To the extent foreign supply accounts for a significant share of total supply, growth in home incomes, ceteris paribus, will lead to growth in home demand for foreign exports. This is the home import-led growth channel for the global economy. By the same token, substituting foreign with domestic supply could be a source of growth for the home economy, for a limited time, until all of foreign supply is eliminated. This is the home import-substitution channel for home growth.

The ceteris paribus phrase, in (i) and (ii), covers many things including: that prices faced at the border by exporters and importers are unaffected, public policies that create a wedge between border and domestic prices remain the same, and more broadly, supply and demand conditions including technology, tastes, market structure, exchange rate policy regime, etc. remain the same as growth takes place. Clearly these are strong assumptions. For example, there is an on-going debate about whether global macroeconomic imbalances will be reduced or eliminated and about alternative adjustment policies for doing so. The exchange rate and macroeconomic outcomes of alternative adjustment policies will have implications for global growth and in particular, whether China and India or any other country will replace the U.S. as global growth engines (Williamson, 2005). Though relevant, this topic and other implications of changes in macroeconomic policies (e.g. monetary and fiscal) for macroeconomic stability and growth will not be covered in this paper. However, changes in policy regimes leading to trade and investment liberalization as well as technological changes (e.g. information technology revolution) could have significant impacts both on the growth of individual countries and industries and on growth of the world economy. I will attempt to account for such changes to the extent possible given what is known or projected.

2. Growth of China and India and its Influence on the World Economy

2.1 Indicators of the Extent of Integration in World Markets for Goods and Services

An overall indicator of integration is the extent of international trade in the domestic economy as measured by the share of exports and imports in GDP and in the global economy as measured by the share of a country's exports and imports in global exports and imports. The relevant data are in Table 1 below.

Table 1

Sources:(1) For shares in GDP, World Bank (2005a), Table 4.9

(2) For shares in World Trade, WTO (2005), Tables I.5 and I.7

It is clear from Table 1 that although both countries have become increasingly integrated with the World Economy, China has gone much farther, even allowing for the fact that China started the process of integration at least a decade earlier. Thus with twice as much or more share of exports and imports in GDP, more than seven times (five times) the share in World merchandise exports (imports), China is better positioned in 2004 for influencing (and also being influenced) by growth of the World economy. Interestingly, during the period 1990-2003 while the share of exports and imports in India's GDP almost doubled, the increase in share in its World merchandise exports, proportionately, was far less. Thanks to its success in the IT service sector, India's share in World exports of commercial services tripled during the same period. It would seem that in India's case, with the possible exception of services the effect of greater integration is largely one-way and domestic, in the sense of its raising the rate of GDP growth and the share of trade in domestic GDP, rather than India's more rapid GDP growth influencing global GDP growth significantly.

2.2 Shares of China and India in Global GDP and its Growth

The measures of integration in Table 1 in effect proxy the potential for the growth of China and India to contribute to growth in the World Economy - put another way, if these measures were zero, so that China and India were autarkic, then obviously their growth would have no effect on the growth of the other countries of the World. But on the other hand, even if positive, the measures do not necessarily imply that the growth of the two countries had or would have, significant impact on global GDP growth or on the growth of low and middle income countries (or alternatively to the growth of developing Asia). Table 2, based on World Bank data, quantifies the impact in an accounting (not to be confused with causal) sense. Table 3 is from Jorgenson and Vu (2005) who use purchasing power parity based exchange rates.

Table 2

SOURCE: World Bank (2005), Tables 4.1 and 4.2

Table 3

SOURCE: Jorgenson and Vu (2005) Appendix Table 1

A comparison of Tables 2 and 3 establishes that adjusting for purchasing power parities makes a substantial difference to the shares of the two countries in global GDP and growth. Still the two tables agree on the following:

i. The shares of the two countries (GDP levels and growth) have been increasing over time, although more so in the case of China than India. The two together accounted for more than a sixth of global growth during 1990-2003 (Table2), and as high as a third during 1985-2003 (Table 3) once adjustment for PPP is made.

The relative share of China's growth in global growth compared to India's increased from around 2.0 in 1980-90 to 3.8 in 1990-2003 (Table 2). Interestingly, when adjustment is made for PPP, the relative share of China decreased from about 3.0 to 2.1 (Table 3). This suggests that relative to India, prices in China seem to be moving closer over time to world prices, confirming once again the findings of Table 1 that China is integrating with the World economy faster than India. The revised GDP data for China, which raise growth rates over 1993-04 compared to old data and also show that China was poised to become the World's 6^th largest economy in US$ terms(World Bank, 2006, p21) strengthen this conclusion.

Unsurprisingly, these two large developing economies account for a large share of GDP and growth of low and middle income countries (Table 2) and of developing Asia (Table 3).

The IMF (2005) recognizes that policy makers in India are actively seeking to strengthen India's global linkages and to accelerate its integration with the World economy. Success in these efforts would increase the role of India in the World economy. The report explicitly refers to one of the mechanisms, India's import demand, through which this would come about. To wit,

A dynamic and open Indian economy would have an important impact on the world economy. If India continues to embrace globalization and reform, Indian imports could increasingly operate as a driver of global growth as it is one of a handful of economies forecast to have a growing working-age population over the next 40 years. Some 75-110 million will enter the labor force in the next decade, which should-provided these entrants are employed - fuel an increase in savings and investment given the higher propensity for workers to save.

2.3 Sources and Sustainability of Growth

2.3.1 Factor Accumulation

China is already well integrated with the World economy. Indeed the share of international trade (exports and imports of good and services) in its GDP at 66% (Table 3) is very high for an economy of China's continental size and level of per capita income. It would be surprising indeed if the share will rise to much higher levels in the future. In China the share in population of persons in the working age (15-64), already at 65.7% in 2003, will not rise by much, if at all, and is more likely to fall in the coming decades. This reflects the effects of the draconian and coercive one-child policy instituted in 1979 and also the decline in fertility in the decade before. The dependency ratio will rise, if not in the next couple of decades, certainly soon thereafter. Its savings and investment rates at 47% and 44% of GDP (World Bank, 2005a, Table 4.9) respectively are also unlikely to be sustained indefinitely. These two facts suggest that from the input (labour and capital) side there will be a downward pressure on China's growth. On the other hand, as Perkins (2005) notes, China still has a large proportion of people of working age employed in agriculture and rural activities, with lower productivity than non-farm workers. He estimates that China's non-farm workforce could increase by another 70 to 100 million in the next decade depending on assumptions about expansion of senior secondary and university education. Thus, productivity gains from the intersectoral shift of labour as well as other changes that increase total factor productivity including technological improvement, could more than offset the downward pressure on growth so that aggregate GDP growth could be sustained in the ranges of 8% to 10% a year for the next couple of decades.

In India's case, demographic trends are more favorable than China's. It is true that some of the Indian states (mainly in the South but also in the West) have achieved fertility rates at or below replacement level (without the use of an abhorrent and coercive one-child policy as in China) and hence will soon experience an increasing old-age dependency ratio as in China. However in the rest, which account for more than half of India's population, fertility rates, though declining, are above replacement. Hence, India's population of working age will rise as a share of total population in the medium term. India lags behind China in the educational attainment of its workforce and hence its catch-up with China on human capital accumulation will also contribute to growth. Moreover, with a much larger share of the workforce employed in agriculture and other low productivity activities, India has greater potential than China to experience significant productivity gains from intersectoral shift of labour. Also India's saving and investment rates around 30% in 2004-05 are likely to increase further for life-cycle as well as other reasons. In brief, India can sustain, and in fact increase, the contribution of accumulation of human and physical capital in its growth.

The GDP weighted average of the rates of gross capital formation in 1990 and 2003 were respectively 42% and 24% of GDP in China and India. Their growth rates of GDP during 1990-03 were respectively 9.6% and 5.9% in China and India (World Bank, 2005, Tables 4.1 and 4.9). China thus invested 18% more of its GDP than India, but its growth rate exceeded India's only by 2.7% per year. This implies that China's incremental capital-output ratio as measured by the ratio of differences in investment rate to the difference in growth rate i.e. 18/2.7 = 6.7 was substantially higher than India's. Revisions of China's and India's GDP data are unlikely to change this ratio much. Although, prima facie this would lead one to conclude that China is using capital far more inefficiently, two facts suggest such a conclusion may be too facile. First, the composition of China's GDP with its far higher share of more capital intensive industry (manufacturing) at 52% (39%) compared to India's 27% (16%), and lower share of less capital intensive services at 33% compared to 51%, and second, China seems to have invested more in capital intensive infrastructure including housing. Indeed, services have been the driving force behind India's recent growth. There is some recent evidence that growth of India's manufacturing sector is accelerating. If sustained, and if growth in services (and agriculture) does not slacken, aggregate growth rate will rise.

2.3.2 Growth in Total Factor Productivity

It is conventional wisdom, dating back to the analysis of components of the then rapid growth in the Soviet Union in the fifties, that growth, if it depends largely on factor accumulation, is unlikely to be sustainable since factor accumulation cannot continue forever. On the other hand, growth that is driven largely by total factor productivity (TFP) growth can. I already noted in the previous section that there is some evidence to suggest that China may be unable to sustain its investment in physical capital and its labour force growth. It is therefore of interest to look at available evidence on TFP growth.

As is well known, TFP growth estimates are highly sensitive to the data used and above all to the methodology of estimation. Extreme caution is called for in interpreting them and using them for policy analysis. With this caveat, let me refer to available TFP growth estimates, based on different methodologies, data series and time periods for China and India. I will be selective in reporting only some, but not all, available estimates. Jorgenson and Vu (2005) focus on the possible impact on growth of the information and communication technology (ICT) revolution, by breaking up capital into ICT and non-ICT capital. They also account for human capital accumulation by distinguishing between growth in labour hours and labour quality. Their decomposition of growth is shown in Table 4

Table 4 - Sources of Output Growth in China and India (% Per Year)

SOURCE: Jorgenson and Vu (2005), Appendix Table 2

Table 4 suggests that while India experienced an increase in TFP growth from 2.06% to 2.49% per year between the two periods, China's TFP growth declined from an astonishing 6.33% per year to a reasonable 2.49% between the same two periods. The contribution of TFP growth to GDP growth remained virtually unchanged at 41.0% and 40.0% in the two periods in India, while it declined from 64.3% to 34.9% between the two periods in China. It is probable that the decline in GDP growth in China in the second period was in part the impact of the East Asian financial crisis of 1997. Also the revision of GDP growth upward by about 0.5% per year on an average in this period in the new data will reduce the fall in TFP growth rate by that amount without reversing it.

A recent and detailed estimate (Table 5) of TFP growth for India is by Virmani (2002) who breaks down the period 1950-51 to 2003-04 into four sub-periods roughly corresponding to the prime-ministerships of Nehru, Indira Gandhi, Rajiv Gandhi and the period after the systemic reforms of 1990-91.

Table 5

Source: Virmani (2002)

The acceleration of TFP growth since the initiation of reforms, hesitantly during 1980-90 and systemically in 1991, is evident. It is also striking that in the second period when the economy was very much insulated from the world economy and state controls on the economy were intrusive and extensive, TFP growth fell to almost zero.

Table 6 displays TFP growth rates for China and India by various authors.

Table 6

a - Figures for manufacturing sector only

SOURCES: Srinivasan (2005a) and references cited therein.

Interestingly, by and large, China seems to have experienced a faster TFP growth than India during most of the period 1953-2003, except during 1995-2003 when their TFP growth rates were the same(though the revised data will raise China's ) according to Jorgenson and Vu (2005).

2.3 External Capital Inflows

The role of external capital inflows, particularly foreign direct (FDI) and portfolio investments (FPI) in the growth and global integration of these two countries has captured the attention of analysts. China has attracted and continues to attract far more FDI than India. The difference in PFI flows is smaller but in terms of new private capital inflows China is far ahead.

Table 7

SOURCE: World Bank (2005a), Tables 6.1 and 6.7

A significant part of FDI inflows to China are from the Chinese Diaspora (including residents of Hong Kong and Taiwan) in contrast to India. Also, China's policy of creating special economic zones (SEZs) to attract foreign investment by exempting investors from regulations applicable elsewhere in China (particularly relating to hiring and firing and foreign ownership) and also providing excellent infrastructure (power and communications) was highly successful. India is only now creating SEZs like China's. But limits to foreign ownership apply to different entrants in different sectors and restrictive labour laws continue. Lastly, China's FDI was export oriented and also directed in part to investment in infrastructure. Given the significantly larger shares compared to India's of private capital flows in China's GDP and investment and its tilt towards exports and growth promoting infrastructure, it is clear that greater integration of China in world capital flows contributed to its faster growth and at the same time, their export orientation increased integration in goods markets as well.

To sum up the discussion of this section: taking together the likely evolution of factor accumulation and total factor productivity in the medium term, it is very likely that China would be able to sustain its average growth in the range of 8% - 10% per year. India would be able to raise its growth from around 6% of the last two and a half decades to 8% or more. China's integration with the world economy is already high. India's integration will continue to increase so that it will play a larger role in influencing the growth of the world economy than in has done until now. Also, China's policies towards external private capital flows were successful in attracting substantial flows and their use in export oriented and infrastructural activities not only contributed to growth but also increased China's integration in goods markets. This trend is likely to continue in the medium term. India is only now instituting Chinese- like policies towards capital inflows and their impact is as yet uncertain. But based on evidence from surveys of investor intentions there are reasons to be hopeful.

Let me now turn to the likely impact of greater integration of India and China with the world economy from a disaggregated perspective.

3. A Disaggregated Perspective

As noted earlier, rapid income growth in China and India, ceteris paribus, will obviously increase demand for goods and services for final and intermediate use. Part of this increase in demand will be met by imports. It is likely that increase in demand would be matched in part by increase in domestic and foreign supply and in part by increases in relative prices. The increase in supplies would itself be a response to price increases and also any induced technical changes and search for alternative sources of supply. Obviously without building and estimating a well specified, disaggregated, dynamic, multi-country global model in which policy variables are also represented, it is impossible to make projections of increases in demand, supply and their equilibrium price consequences. This understood, I will explore how export supplies currently match global import demand. This will at least given an indication of where the pressures on demand and supply are likely to emerge with global economic growth, and indirectly, the implications of rapid growth of China and India. Table 8 gives the relevant data.

Table 8 - Share of China and India in World Trade (Percent)

Notes: n.a. =not available, ^a =pertains to 2000, ^b = pertains to 2003

Source: WTO (2005) Tables I.7, IV.26, IV.27, IV.28, IV.34, IV.39, IV.40, IV.46, IV.47, IV.48, IV.67, IV.68, IV.74, IV.76, IV.83, IV.84, IV.87, IV.90, IV.93

Several interesting facts emerge from Table 8. First, China has emerged as a major exporter of manufacturers since 1990 with a global share of 8.3% in 2004. India is not yet a major exporter to the world. Within manufacturing, China has a significant share of world markets for iron and steel, office machines and telecommunications equipment and, not surprisingly, in textiles and clothing. Except for textiles and clothing, where India's share has grown modestly to 4.0% and 2.9% of global exports and less so to 1.6% in iron and steel exports, India's shares are very small and not growing. Let me now turn to a few specific industries.

Textiles and Clothing:

It is well known that as quotas under the Mutifibre Arrangement (MFA) were being phased out from 1995, China took advantage of the elimination of quota markets in the USA and the EU markets and rapidly increased its share in the two markets. After the MFA was completely phased out (in fact, in anticipation of it) on January 1, 2006, Chinese exports in both markets increased rapidly leading to what is in effect, a return to the bad old bilateral quotas of MFA! India did not, and in fact could not, take full advantage of the gradual phase-out because of domestic constraints, including in particular, the reservation of garments for production by small scale enterprises (the reservation was lifted only three years ago) and restriction on textile imports. In the post MFA scenario, given appropriate policy changes, India could do better and indeed gain global market shares, although perhaps not as much as China.

A study by Nordas (2004) suggested that China and India could capture 29% and 9%, respectively, of the EU markets and 50% and 15%, respectively, of the US market. However, the simulations of Ananthakrishnan and Jain-Chandra (2005) of the effects of MFA quota elimination using an applied general equilibrium model of the Global Trade Analysis Project (GTAP Version 6), and taking into account the current safeguard restrictions of China's exports to US and EU, are not optimistic for India. While India's exports will grow, with the expiration of safeguards on Chinese exports in 2008, growth will decline. Largely because of adverse terms of trade change (i.e. falling export prices due to competition) the welfare effect of the expiration of MFA is negative for India, with the welfare loss being smaller, with safeguards on China in place. The authors note the initiation of domestic reforms in Indian textile and apparel industry in 2004 and expect their beneficial effects to emerge after a lag. They end their paper with the banal note, “India could emerge much stronger and expand its trade in textiles and apparel at a much faster pace if some of the key weaknesses are overcome” (p29)!

In an interesting review of the role of price and cost comparativeness in apparel exports in the first MFA scenario, Tewari (2005) takes note of these detailed studies of the Indian situation and concluded that with, the removal of impediments such as the high cost of imports like energy, dyes and chemicals, and by raising the scale of production and improving productivity (particularly of labour), India can compete with China. She points out, as the authors of the studies she surveyed themselves recognized, the limitation that their studies partly neglect the fundamental ways in which the structure of apparel production sourcing and trade have changed in recent years. She concludes that in the new environment, ample opportunities still exist for building lasting competitive advantage based on creativity in production, skill formation, technological innovation in marketing and distribution, and the creation of supporting institutions to help firms and workers adapt continually to volatile markets. This is a tall agenda that in principle is relevant for other industries besides textiles and apparel. However the benefits from and costs of its implementation are unknown. In any case it is not clear whether India is capable of implementing it.

Automobiles and Parts

Both China and India have tripled their share of global auto parts market between 1990 and 2004 (Table 8), though the shares are still small in both countries, and much smaller in India than in China. However, there are reasons to believe that both can emerge as significant players in the global market. There were only three private firms producing passenger cars in India and their capacity was heavily constrained by the government through licensing until the early eighties when a new public sector firm with Suzuki motors as collaborator was allowed entry into the market. It began a transformation of not only of India's passenger car components but also the entire auto industry including its auto parts component. As IMF's Rughuram Rajan noted, once entry barriers against foreign producers were removed and capacity licensing doubled with the reforms of 1991, not only foreign producers entered the market, but soon found out that it did not make sense for them: to continue sourcing their sub assemblies from outside India. Instead, they started developing local ancillary manufacturers, and gave them the technological assistance for them to become world-class. Soon India started exporting ancillary automotive products to the developed world.

The story does not end here. Telco [a domestic enterprise], capitalizing on the existence of world-class suppliers of ancillaries in India, started producing a state-of-the-art, indigenously-designed car, the Indica. The car had teething problems at first and was rejected by a now-discriminating public. But Telco engineers went back to the drawing board, fixed the flaws, and brought out a new version that swept the market in its category. From about 50,000 cars in the early 1980s, India produced over 1,200,000 in 2004, and exported 160,000 cars, many to the developed world. (Rajan, 2006, p 4).

Sutton (2005) examined the extent to which Chinese and Indian auto component producers have advanced towards international best practice levels of productivity and quality through a survey of nine car manufacturers in China and six in India and a range of general component suppliers in both countries with detailed bench-marking of six seat producers and six exhaust suppliers in each country. The main finding of the study is that “the development of the auto industry supply chain in both China and India has proceeded very rapidly at the level of car makers and their first-tier suppliers: here current standards of supplier quality are at, or close to, world standards. The main weakness of the supply chain lies in the fact that best practice techniques are permeating down to second tier suppliers in a very slow and uneven manner. The similarity in the pattern across both countries is striking” (Sutton, 2005, Executive Summary). It found also that “While the development of the local supply chain in both countries has in large part been driven by the presence of multinational car makers, component exports are driven equally by multinational and domestic firms. Both India and China have a substantial body of purely domestic firms that have achieved major successes in export markets; of the top ten component exporters in China, six are domestic firms; of India's top 10, half are domestic firms (and three of these belong to a single domestic industrial group” (ibid). It would seem that the prospects for both China and India to play a major role in the evolution of global auto and parts market are bright. This will intensify the competitive pressure on established auto (particularly auto parts) firms in industrial countries. This is already evident from the bankruptcy of the component makers Delphi in the US. Apparently, the Indian government has come to recognize the growth potential of the automobile industry. According to a report in The Hindu of March 11, 2006, the Finance Minister P. Chidambaram said that “We will become a global manufacturing hub for small cars in the next 3 to 5 years… we will emulate this success story in other sectors to be among the top global manufacturing centres” (http://www.hindu.com/2006/03/11/stories/2006031106491200htm).

It has been argued that in India employment elasticity of GDP growth in general and manufacturing in particular is low and falling (PC, 2002), which in turn implies that growth rates of output would have to be very high for demand for labour to grow significantly. Further if the source of such high output growth are to be either domestic demand or export demand, are high growth rates of either or both likely? I would argue (Srinivasan, 2006) that the employment elasticity and inferences based on it have no analytical foundations. Elementary economics would suggest that the observed employment in any period represents an equilibrium between labor supply and labor demand. In principle, both supply and demand functions could shift over time. For example, GDP growth, ceteris paribus, would shift the labour demand function outward. Similarly, growth of the number of individuals in the prime working ages due to population growth, ceteris paribus, shift the supply curve outward. Depending on the relative strengths of these shifts almost any trend (up, down or no change) in equilibrium employment is possible. In other words, the so-called “employment elasticity” is not a deep behavioral parameter and can take on any number, positive or negative. It is what econometricians would deem a “reduced form” rather than a “structural parameter”.

Even if one were to treat the elasticity as economically meaningful, there is no reason to assume its past low value will prevail in the future as well. In fact, three are reasons to suggest that the elasticity will rise. First, there is evidence the rural demand for manufactured products, particularly consumer goods (durable and non-durable), has begun to grow rapidly. Second, with enabling reforms, such as elimination of reservation products for exclusive production by small scale industries, improvements in infrastructure (power, transportation and ports) India could increase its low share of exports of labour intensive manufactures as China has done. Indeed, if India were to move quickly to let FDI into retailing, not only domestic demand for various manufacture products will rise, so will export demand. There is no reason to be unduly pessimistic about growth in demand.

India's Parliament approved legislation in 2005 for establishing special economic zones (SEZs). Export processing zones established in the past had not been very successful. The creation of the SEZs was inspired by the success of similar zones in China, particularly in attacting FDI. However, some of the crucial features of China's zones, such as allowing 100% foreign ownership, freedom of enterprise managers to hire and fire workers as they see fit for due cause, and the provision of excellent transport and communications infrastructure, are missing in India's zones. There are still sectoral caps for FDI. Exemption from draconian labour laws (a state subject under India's constitution) has been left to the states. Although efficient infrastructure has been promised it remains to be seen whether it will be delivered. I would argue that the only rationale for setting up such zones would be that political and administrative constraints prevent turning the entire country into such a zone in one fell swoop. If that is indeed the case, while establishing such zones, a policy of extending them to cover the entire country soon has to be announced at the same time. This has not been done. While I do not expect the zones to be spectacularly successful, I do expect some modest success, particularly in attracting FDI to emerging manufactured exports and exports of IT services.

In China, the rapid creation of urban and infrastructure development in the coastal cities (Shanghai, and Guangzhou) and zones is reported to spurred industrial development driven by agglomeration/urbanization economies and weak labour laws. I have already mentioned the reluctance in India to reform labour laws. However, metropolitan cities, the hubs of manufacturing in the colonial era, such as Ahmedabad, Chennai, Kolkata and Mumbai are reasserting themselves as centres of industrial development. Also, other large cities (e.g. Coimbatore, Pune, the national capital region surrounding Delhi and others) are also emerging as industrial centres. Of course, because of early investment (particularly private investment) in engineering education in the states of Andhra Pradesh, Karnataka, Maharashtra and Tamil Nadu, information technology centres came to be established in their cities (respectively, Hyderabad, Bangalore, Mumbai-Pune corridor and Chennai). However, the pace of the development manufacturing hubs would be dependent on whether the reform process will be accelerated, deepened and extended. The reform agrenda has to include labour and bankruptcy laws but also land right/land market issues in urban areas. Certainly making India's court system to function more efficiently and speedily in resolving commercial disputes has to be part of the reform, although China has not been hurt particularly by its having no conventionally defined legal system. Whether in the long run the creation of a dispute settlement system outside of the traditional judicial system (e.g. special tribunals, lok adalats, etc.) will create incentives or obviate the need for reform of the judicial system is arguable. It certainly has short term benefits. But long term and substantial benefits of the reform of the judicial system should not be lost right off.

Pharmaceuticals and Chemicals

India emerged as a major producer of generics by the mid 1990s in large part because India's patent laws of the period did not offer patents to producers but only to processes. As long as the process used by the Indian generics producers differed from the process used by the producers of the corresponding branded drug under patent protection elsewhere, they were free to produce and market the generic product at home and also export it to those countries where the branded drug was not under patent protection. Alas, this has changed with India's signing of on the Uruguay Round agreement of 1994, including Trade Related Intellectual Property Rights (TRIPS). After the period of 10 years from 1995 allowed to bring its patent laws into conformity with TRIPS, India amended its law in 2005 and now has to offer product protections as well. It would take me too much afar to discuss the merits of TRIPS and its possible consequences for developing countries. Suffice here to say that the recent clarification of the compulsory licensing (and public health) provision of TRIPS has opened the door for India's highly competitive generic producers of life saving drugs, including retroviral for HIV/AIDS, to expand their markets abroad. More generally, with India emerging as an inexpensive and attractive place for trials of new drugs, and also the rising confidence of major Indian pharmaceutical companies in their ability to innovate and compete in the post TRIPS era, India could emerge as a significant pharmaceutical hub. The potential growth of China and India as suppliers of industrial chemicals is also high, with both having nearly doubled their share in global exports of chemicals.

Services

Service sector has been the most dynamic in India's economy in recent years, with a growth rate exceeding 7% per year during the last five years (MOF, 2006, Table 1.2). This sector accounted for as high as 54% real GDP in 2005-06. Business and commercial services together with finance, insurance and real estate services accounted for 13.5% of real GP in 2005-06, trade, hotels, transport, communication and storage services accounted for another 26.2% and community, social and personal services accounting for the remaining 14.3% of GDP. In 2004-05 and 2005-06, the growth rate of services sector was 9.9% and 9.8% respectively, with the component trade, hotels, transport and communication services growing at 10.6% and 11.1% respectively in the two years. Clearly, the widely noted software services, though rapidly growing, is only a relatively small component of the vast service sector. Domestic demand is a crucial contributor of growth in transport and trade, transport, storage, community, social and personal services and to some extent in communications, hotels and financial services. Software has a dominant export demand component. Hotels, communications and financial services depend also on foreign sources of demand from tourists and foreign investors. With demand for many of these services being income elastic, it is very likely both domestic and foreign demand growth will enable India's service sector to sustain its recent rapid growth.

Labour intensive services are another potential source of growth for the two economies as well as the impact of their growth for the world economy. Realizing this potential depends to a significant extent on the outcome of service sector negotiations in the Doha round. In the unlikely scenario of considerable liberalization of service supply by Mode 4 (supply of services by temporary movement of natural persons), India and China could expand their supply of labour intensive services to the world markets.

The heated debate on outsourcing and the plethora of protective legislation that has been proposed to contain it in the United States relate to supply by Mode 1 (trade in services in which the supplies and the user remain in their respective locations). Again, the potential growth of these service sectors and their impact on growth in India have been discussed in the literature (Srinivasan 2005b). The data on Table 8 show that India had a 3.1% share (one of the very few commodities or services in which China's share was smaller than India's) in the global market for other commercial services, of which the outsourced services form a large part. The export of these services from India has been growing rapidly. Net exports of software services at $16.5 billion accounted for more than half of India's total service exports (net) of $31.2 billion in 2004-05. In the first six months (April-September) of fiscal year 2005-06 software exports totaled $9.8 billion, a growth of 30% over the corresponding period in 2004-05 (RBI, 2006, Table 45). An industry study group estimates that remote (such as exports) and in situ provision (such as tourism, healthcare and education) of services can add 0.6% - 1% to annual GDP growth, and generate additional employment of between 20 and 72 million by 2020 (Srinivasan, 2005b). The growth and quality upgrading (i.e. moving up from call centers to software or technology development and research centers) has been so fast that there are fears of an emerging talent crunch. The latest report from India's National Association of Software and Services Companies (NASSCOM) foresees a “potential shortage of skilled workers in the next decade or so, particularly in the BPO industry, [as] currently only 25 percent of technical graduates and 10-15 percent of general graduates are suitable for employment in offshore IT/BPO industries.

MGI (2001) finds that the labour productivity of India software companies is at 44% of U.S. levels and individual service companies have the potential to reach 100% of U.S. levels. In fact, best practice companies in India already match the U.S. average. MGI (2001) points out that the software industry grew at a rate of over 50% a year for five years to reach an output of $2.2 billion in 1999. With the worldwide IT services market growing at 8% a year and set to reach $910 billion by 2010, and demand from domestic end user industry expecting to grow at 30% a year for a decade, MGI (2001) sees a potential output of $46 billion by 2000 (more than 20 times its level in 1999) with exports absorbing $25 billion and domestic sales absorbing the remaining $21 billion. Like NASSCOM, it also recognized that the biggest bottleneck to future growth is the availability of good software talent.

Interestingly, India's success in software and China's success in hardware have generated interest at the highest policy making levels in a collaborative effort to capture a sizeable share of the global market for both. Former Chinese Prime Minister Zhu Rongji first pointed out this possibility during his visit to India in 2002. During current Prime Minister Wen Jiabao's Indian visit in 2005, a similar view was expressed in a report to the Prime Ministers of China and India by the India-China Joint Study Group (Srinivasan, 2005b).