China, India and the world economy

4. Policy Implications

Not so long ago, in the 1950s and 1960s, Japanese GDP grew at a rate of about 9% a year for nearly 25 years. Chinese GDP growth since 1980 has also averaged around 9% and this rate of growth could be sustained for another decade or two. India is following behind China, with an average growth rate of close of 6% a year since 1980, with some evidence that growth is accelerating and can be sustained at 8% a year in the coming decades. With populations of 1.3 and 1.1 billion respectively in 2003, the two giant economies of China and India, on the one hand, present a huge and fast growing domestic market for a range of goods and services, and thus export opportunities for producers in the rest of the world. On the other hand, many in the already rich and established industrial nations view their increasing competition for the world's raw materials and their increasing shares in the global markets for a range of goods and services, as a threat to their prosperity and growth.

Large and growing market opportunities in China and India are widely seen and understood as evidenced by the large flows of foreign direct investment to China, both for the domestic market, but also to use China as a low cost platform for exports to the rest of the World. Although India has attracted far less FDI, it is not because of the lack of potential opportunities in India, but largely because of policy hurdles and other constraints on investment. This restrictive environment is expected to change - recognition by policy makers of the need for change has resulted in the recently enacted legislation for the creation of Special Economic Zones in which the incentives for profitable investment are expected to be higher. This is not to say that with the establishment of SEZs the flow of FDI will sharply increase in the very near term, but that with their establishment and the adoption of other essential policy reforms, such an increase can be expected in the medium term.

Turning to the competition from China for raw materials (and India, though it has not attracted as much attention), Anthony Poole (2004) cites Deutsche Bank for the finding that China's vast manufacturing industry has consumed 20% - 30% of world trade in aluminum, copper, iron ore, stainless steel and zinc in 2003 and these percentages are expected to rise in the future, assuming of course, China's rapid growth is not a bubble but will be sustained. It is widely noted in news media that China and India are competing aggressively and with each other to secure energy supplies from central Asia, Africa and Latin America. While the growth of world demand represents rising opportunities for foreign raw material suppliers, to the large extent it is driven by China also means greater dependence on Chinese demand. Any disruption in Chinese demand in the short run can be costly for suppliers. Similarly, foreign users who depend on China's exports for a sizeable share of their total use, could be faced with the prospect of having to search for alternative supply sources if Chinese exports are disrupted for whatever reason. Of course, shocks to China's import demand (and export supply) are sources of risk for foreigners. However, as long as shocks to foreign export supply (import demand) are not too highly correlated with China's shocks, dependency on China could be a source of insurance for foreigners. More generally, whether greater dependence on external trade will increase volatility or provide insurance depends on the nature of shocks. Since by definition trade is beneficial though it has some risk as well, it could be (and is more likely to be) the case, that the gain in expected benefits would far outweigh the loss due to increased volatility, if any.

From a welfare perspective, acceleration of global growth and trade fueled in a significant part by the greater integration of fast growing China and India would increase the demand for transport and shipping. Already constraints of port capacities and rise of shipping fleets are seen in the rise of cargo rates. But this will be a short-run problem, if the rate increases elicit investment in shipping and port capacities. Also archaic restrictions on cabotage and the opposition of entrenched and strong labour unions in part could pose problems for increasing supply of shipping services. Indeed, the continuing failure since the conclusion of the Uruguay Round to agree on liberalizing maritime services trade in a scandal.

The protectionist response to China's emergence as the third largest trader in the world is seen in the complaints that China does not play by the rules of global trade and manipulates its currency to keep it undervalued. Recent restraints on Chinese apparel exports in the EU and the US is one example of a blatantly protectionist response. Other examples are the creation of an agency within the office US Trade Representative to monitor China's trade practices, and the pending bill in the Senate that would impose an across the board 20% tariff on imports from China, if it does not revalue the renminbi significantly. The potent protectionist tool of anti-dumping can always be invoked as it has been in the past to respond to increased import competition in particular industries. In the case of India, the protectionist response is seen in the spate of legislation in various states in the US that have been adopted or are pending that prohibit off-shoring of services by government agencies.

To contain and forestall the rise of protectionism in the rich countries, the importance of successfully concluding the Doha round cannot be overstated. China and India are members of the Group of Twenty-plus (G-20) developing countries that was formed at the failed ministerial meeting of the WTO at Cancun, Mexico in 2003. Since a successful outcome of the Doha round depends on mutual exchange of market access expansions, to the extent China and India are able to persuade the G-20 and the larger group of developing countries to be more forthcoming in reducing barriers to their markets, the probability of a successful Doha outcome will be increased. There is some evidence that both are attempting to do so. Still the prospects of a successful completion of the Doha round by the end of 2006 do not seem bright (Evenett, 2006).

Turning to implications for domestic policy in China and India, there are several studies documenting various barriers to greater integration in India. Before turning to them, let me be clear about one policy that I will not entertain: it is the so called “industrial policy” that picks potential industries that will be winners in the global markets and targets policy support to ensure their success. Contrary to the continuing belief in “industrial policy” as the source of successful growth and development in Japan and other East Asian countries, the empirical evidence underlying this belief is not entirely persuasive. Moreover there is evidence that China has failed in its attempt to pick and nurture winners and still has not abandoned such attempts. For these reasons, I will neither attempt to discern future winners from the past performance described in the previous sections nor discuss policies that are targeted at particular sectors and industries. What in my view is far more relevant is the general incentive structure or climate that is supportive of and not an impediment to innovation, risk taking and efficient resource allocation in the economy.

Let me turn to India first. IMF (2005, Box 1.4) correctly notes that:

Various factors have hindered India's integration. Despite substantial tariff reductions in recent years, India remains a relatively protected economy, with tariffs averaging 22 percent (18 percent in trade-weighted terms)-above the average emerging Asia and global tariff rates of 9 Ѕ percent and 11 Ѕ percent respectively-and significant nontrade barriers remain. Moreover, a range of structural; impediments-including restrictive labor laws and onerous red tape-have retarded the growth of manufacturing, which has been the main driver of export-oriented growth in Asia. Reflecting this, the contribution of industry to GDP and employment, at 27 percent and 34 percent respectively, remains well below that of Asia as a whole. Foreign direct investment (FDI) has been hindered by a difficult business climate as well as by caps on FDI in certain sectors (Jain-Chandra, 2005). And the growing inadequacy of India's infrastructure constitutes a major obstacle to private investment and export potential.

The World Bank collaborated in two investment surveys carried out by the Confederation of Indian Industry (CII) in 2000 and 2003. McKinsey Global Institute (MGI, 2001) came out with its report based on a fifteen-month long project on India's economic performance. It examined 13 sectors in detail, two in agriculture, five in manufacturing and six in services, accounting in all for about a quarter of India's GDP.

The World Bank (2004) report begins with the assertion that differences in investment climate explain variations in competitiveness, growth and prosperity across countries or across sub national units within countries. The constituents of investment climate are institutional and policy variables that have a crucial bearing on business performance, but on which firms have no control individually. The major determinants of investment climate included: functioning of product and factor markets, industry spill-overs and externalities, governance indicators relating to law and order, regulation and public goods provision, cost of credit, inflation, exchange rate regime, as well as physical and social infrastructure. Fiscal, monetary and exchange rate policies, and some governance indicators influence some of the other critical determinants. The report assesses the investment climate from the perspective of India's industrial growth and global competitiveness, in particular in relation to China. Without reproducing the details of the assessment and the recommendation, let me quote: the performance gap between Indian industry and its international rivals - particularly Chinese industry - has a great deal to do with investment climate. So does that between high-FDI or high-growth states in India and less successful regions … [although] specific policy measures cannot be inferred, at least directly, from a diagnostic analysis … [it is clear] that at least two interrelated sets of regulatory and institutional reforms are needed in order to improve India's investment climate. The first comprises a set of regulatory reforms, including reducing entry and exit barriers to manufacturing industries, addressing impediments to the smooth functioning of labor, land, and product markets, and streamlining the regulation of business startups, bankruptcy procedures, and industrial and trade routines. The second reform set would address institutional and regulatory impediments, physical infrastructure and financial and other business services. (p.v)

The report of the McKinsey Global Institute in many ways comes to a similar conclusion as the report of the World Bank. It finds that (MGI, 2001, pp.2-5):

Product market barriers and the rules and policies governing different sectors of the economy impede GDP growth by 2.3 percent a year.

Particularly damaging features of the current regulatory regime are: inequitable and ill-conceived regulation, uneven enforcement, reservation of products for small-scale enterprises, restrictions on FDI, and licensing and quasi-licensing requirements.

Unrecognized land market distortion accounts for close to 1.3 percent of lost growth per year. These distortions include unclear ownership, counter-productive taxation, and inflexible zoning, rent and tenancy laws.

Government-controlled entities, accounting for 43% of capital stock and 15% of employment outside agriculture have lower productivity of capital and labour compared to their private competitors. Their suppression of potential competition and productivity improvements result in the loss of 0.7 percent GDP growth per year.

Contrary to common belief, inflexible labour laws and poor transport infrastructure are minor barriers to growth and together account for less than 0.5 percent of lost GDP growth.

One need not take the numerical estimates of lost growth in the McKinsey report literally nor agree with the conclusion that labour laws and infrastructure are minor barriers. I do not. Most of the thirteen policy recommendations in the report (it is interesting that, unlike the World Bank (2004), McKinsey Institute does not hesitate to draw policy conclusions from a diagnostic survey) are evidently sensible. They include removing reservations on products to small scale manufacturers; rationalizing taxes and excise duties; establishing effective, pro-competition regulation and powerful, independent regulators; removing restrictions on foreign investment, reforming property and tenancy laws; and widespread privatization (MGI, 2001, p7). The report concludes that the implementation of the recommendation over two to three years will boost growth to 10% per year.

In a paper for the Deutsche Bank Research, Teresita Schaffer and Pramit Mitra conclude that it is too early to deem India a global power, although “Its stable democratic political system, huge middle-class population, immense military clout in South Asia, rising economic fortunes and global ambitions make it a potential power that could (if things go well) play a very important role in world affairs.” In their view,

To become an economic powerhouse and catch up with its bigger rival [China], India will have to sustain at least 8% growth, over a long period of time. Its first challenge will be to address some structural issues in the economy. These include reining in the runaway fiscal deficit, freeing its manufacturing sector from antiquated labour laws, selling state-owned assets and using the freed-up cash for investments in physical infrastructure … India's growing HIV/AIDS epidemic could seriously slow down its economic growth and threatened the country's public health structure. Ironically, AIDS has had its most severe effect on some of the most prosperous parts of the country. Unless they take vigorous action soon, it could erode a major economic advantage: a large pool of inexpensive and skilled labour.

Their analysis, except for their drawing attention rightly and importantly to HIV/AIDS, overlaps that of the World Bank and McKinsey Institute.

Last, and in many ways a disappointment, is the report of the Indian government's National Manufacturing Competitiveness Council (NMCC, 2005). It also recognizes some of the same constraints that the other reports do. Its final chapter of thirteen pages consists of its conclusions and key recommendations. It follows the pattern of many government reports and appraisals (such as the ritualistic mid-term appraisals of various Five Year Plans), by including many goals and aspirations, and a laundry list of what should be done with no any sense of priority among them nor a time frame and assignment of responsibilities to specific agencies for doing them.

It can be argued that even without major policy reforms, China could (and most likely would) sustain its current growth, certainly in the next decade, and possibly longer. However, whether the political tensions and distributional conflicts that sustained rapid growth of the last 25 years have generated, and their possible exacerbation if growth is sustained for another 20 years, without political reforms, would lead to a violent collapse of the government, is an open question. Although the ruling party appears to be firmly in control, and has enough muscle to put down forcibly the growing number of localized protests, and prevent them from escalating into an organized nation-wide opposition to communist party rule, without political reforms towards a participatory democracy, force alone cannot stop such an opposition from emerging.

Even leaving aside the political problem of its non-transparent, authoritarian, central political control, China lacks some of the key institutional foundations of a market economy. Perkins (2005, p25) argues and rightly, “China should move away from an industrial policy that targets particular industries and firms and requires all manner of regulatory interventions, and instead move steadily toward an industrial policy that concentrates on general support investments for industry such as improvements and expansion of the education system,” and asks whether China has the institutions that such a market oriented approach requires. One needed institution is a well-functioning and efficient financial sector consisting of commercial banks, markets for debt, equity and insurance and a strong regulatory agency. He finds China lacks one. Another is a legal system, with a competent, efficient, independent and powerful judiciary. In his view, the absence of such a system in China, “makes it impossible to efficiently carry out other important changes in the economic structure through the decentralized processes of the market. Instead decisions have to be pushed up to higher level government bureaucrats in the ministries or elsewhere” (Perkins, 2005, p31).

India has much stronger political and institutional foundations than China. Although India is also experiencing distributional conflicts arising from its sustained growth for 25 years, its vibrant participatory democracy offers non-violent means for resolving them through political compromises. Certainly, political compromises take time to bring about and the very fact that they are compromises often means that desirable economic reforms are politically infeasible to implement. On the other hand, it also means that once implemented reforms should be far more sustainable.

India's commercial banking system resembles China's in that it is still dominated by public ownership of nearly three quarters of its assets. Nevertheless it has become more efficient with increasing competition from dynamic new domestic private banks and also foreign banks. India's National Stock Exchange is becoming one of the world's most efficient (comparable to the New York Stock Exchange) in terms of transaction costs and transparency. Indeed, the large inflow of portfolio investments, particularly from foreign institutional investors in response to higher returns in India is in part a testimony to the vibrancy of India's stock market. India's legal system, though by no means efficient, has been functioning for a long time. Its independence and power are respected by the other branches of government. Thus India unlike China, does not have to create a legal system de novo, an enterprise, which as Perkins (2005) rightly notes, will take at least a generation, if not longer.

To say that India's institutional foundations, political and economic, are stronger than China's does not mean that unfavorable comparisons with Chinese economic performance “were irrelevant because China was a dictatorship and India, a democracy,” an excuse that Martin Feldstein (2006) says he once heard from Indian policy officials a few years ago, but no longer does. He concludes,

The optimistic mood in India's business community, the desire for reforms by the top leadership of the government, and the growing number of relatively middle-class households provide a force for change and a source of support for new entrepreneurial activities. If the political leaders can now persuade the traditional opponents of reform that growth can benefit their constituents and that better new jobs will replace the old, India will see decades of remarkable achievement (Feldstein, 2006)

The debate whether China's communist dictatorship or India's democratic system will deliver and sustain rapid and equitable economic growth in the long run dates back to the early fifties, soon after India's independence in 1947 and China's communist victory in 1949. Interestingly, with China having outperformed India since Deng Tsiao Peng opened and liberalized the Chinese economy, and India having grown more rapidly since it began moving away from its inward-oriented, state-directed, development strategy, the current debate is on whether stronger institutional foundations of India would enable India to catch up and overtake China. In concluding the paper let me refer to the provocative questions raised by Huang and Khanna (2003) and Huang (Financial Times January 23, 2006). The first article articulated the view that although India was not outperforming China overall it is doing better in key areas and that success may enable it to catch up with and perhaps overtake China. The key areas in which India performed better included (1) the spawning of internationally competitive homegrown small companies. Out of Forbes 200 of the World's best small companies in 2002, there were 13 Indian firms as compared to China's four (2). India's stronger infrastructure in terms of far more efficient and transparent capital markets to support private enterprise so that entrepreneurship and free enterprise are flourishing. In a survey of leading Asian companies through polling of 2500 executives and professionals in a dozen countries by the Far Eastern Economic Review, only two Chinese firms had high enough scores to qualify for being rated among India's top 10. In the second article, Huang points to the booming stock market in India in contrast to market collapse in Shanghai, and the better functioning of India's financial system despite its many faults in not discriminating as much against innovative small enterprises as compared to China's system.

Wolf (2006) also notes some of India's institutional advantages over China noted earlier: a well-developed private sector; a relatively entrenched legal system; a stable democracy and freedom of speech; a modestly better score on corruption and rule of law in World Bank's governance indicators. He concludes that India's prospects for overtaking China depend on implementing difficult reforms in five pivotal areas: deregulation of labour markets and an end to the small-scale sector; revitalization of agricultural growth; increased investment in infrastructure; elimination of fiscal deficits; and, finally, across-the-board privatization and further trade liberalization

Whether or not India overtakes China in the next two decades, it is clear that both countries will be economic powerhouses in the medium term. Undoubtedly, their growth will have significant impacts on the World economy.

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