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A tale of two giants: India and China

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 2003
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In 1980, India was the fifth largest economy in the world, while China was the ninth largest (in terms of GDP compared at purchasing power parity exchange rates). By 2001, China had leapt to second place, behind the United States, and India had moved into fourth place. Both countries have also witnessed sharp declines in poverty—jointly lifting some one-half billion people out of poverty over the past two decades. At a conference organized by the IMF and India’s National Council of Applied Economic Research in New Delhi, November 14-16, academics and public sector officials sought to identify the factors behind the two countries’ impressive track record over the past two decades. Kalpana Kochhar, Assistant Director in the IMF’s Asia and Pacific Department, presents the highlights of the conference.

Only a generation ago, Lord Meghnad Desai (London School of Economics) noted in opening the discussion, a conference like this would have focused on whether China and India could feed their populations. Today, these two giants account for nearly 40 percent of the world’s population and nearly 20 percent of world output. He highlighted the “historical legacies” that “shaped both the politics and economics of the two countries.” Through much of its history, China was a single nation ruled by a strong central power, whereas India never had (and arguably does not have even to this day) a central authority in control of the whole country. Consequently, it was easier for China to focus single-mindedly on economic reform and growth. In India, attention was focused on holding the country together, thus diffusing focus on the economy.

Lord Desai speculated whether China would be able to continue combining one party rule with capitalism. The 2008 Olympic Games—and the associated global media exposure—could be a turning point in China’s modern political history, he said, as had been the case in the former Soviet Union. He predicted that China would go through a political transition—not to a Western-type democracy but to a system more akin to the democracies in Singapore, Taiwan Province of China, and Malaysia. India would likely remain a soft, consensual state and would not be capable of achieving the remarkable growth rates China has attained, although Lord Desai was optimistic that both countries will succeed in eradicating poverty. He concluded by saying that China will become a great economic power, and India will become a great society.

The service sector in India has experienced the most rapid growth and now accounts for more than 50 percent of GDP.

Poverty reduction—just a matter of growth?

Although poverty reduction in both India and China has been strongly correlated with economic growth, the wide regional differences within the two countries suggest that other policies are also relevant in enhancing the “poverty-reduction efficiency of growth.” In the first session of the conference, participants pointed to female literacy rates, spending on infrastructure, land reform, availability of agricultural credit, and rural industrialization as some of the factors that have led to a faster reduction of poverty.

Furthermore, differences in the sectoral pattern of development may hold some answers to the differences in poverty reduction in the two countries. Both China and India have experienced a sharp decline in the importance of agriculture in GDP over the past five decades. China followed a more typical path of development, moving people and output from agricultural to industrial activities. Also, the increase in the share of industry in GDP in China was matched by a rise in the share of employment in industry.

In contrast, the service sector in India has experienced the most rapid growth and now accounts for more than 50 percent of GDP. However, the increase in the sector’s contribution to output has not been matched by an increase in its contribution to employment growth. India’s relatively jobless service sector growth is unlike the experience of other countries. Typically, the service sector’s share of employment tends to rise faster than its share of output—implying falling labor productivity. In India, labor productivity in services has been rising over time. The available evidence suggests that the increase in labor productivity in services could reflect the fact that services growth in India has been in subsectors more dependent on skilled labor than on capital or unskilled labor.

Is more open better?

In the discussion of whether trade liberalization and foreign direct investment have helped spur growth, the answer from conference participants was a unanimous and resounding “yes,” while in the case of broader capital account liberalization, opinions were more divided.

On trade liberalization, Nicholas Lardy (Institute for International Economics) highlighted the fact that China achieved a stunning increase in trade through unilateral trade liberalization and reform even before its accession to the World Trade Organization (WTO). Key reforms included significant reductions in tariffs and nontariff barriers to trade, unification and devaluation of the exchange rate, and the introduction of a system of rebates and drawbacks of import duties and indirect taxes on exports. These reforms allowed export processing to take place at “world prices, free from tariff or domestic pricing distortions.” Greater openness to trade and foreign investment dramatically increased competition in the domestic market—the ratio of imports to GDP in China is now 30 percent, and the ratio to GDP of imports and goods produced by foreign affiliates sold in China is near 45 percent. Other indicators suggesting the beneficial effects of increased competition include declining employment in the state sector, a sharp decline in the rate of inventory accumulation, and improved profitability in China’s state-owned enterprises.

Professor Arvind Panagariya (University of Maryland) outlined India’s more tentative trade reforms, which nevertheless produced dramatic results in terms of import and export growth (see IMF Survey, December 1, page 345). He drew a distinction between the 1980s and the 1990s in terms of the intensity of trade liberalization. Much deeper trade reforms took place after 1991, resulting in a notable increase in the ratio of international trade to GDP, but India’s share of global trade still remains small in comparison to China’s. In 1980, the ratio to GDP of total trade in goods and services in both India and China stood at about 15 percent. By 2001, this ratio had more than tripled to about 50 percent in China, while in India it had risen to around 25 percent.

On financial globalization and capital account liberalization, participants were more circumspect in their conclusions. Eswar Prasad (Asia and Pacific Department, IMF) said that it is hard to find a strong causal relationship between financial integration and higher growth rates in developing countries. But he also noted that there is evidence of “threshold effects”—that is, beyond a certain level, financial integration does reduce the volatility of consumption. The thresholds can be defined in terms of absorptive capacity of countries—the latter in turn being a function of human capital and financial market development, macroeconomic policies, and governance.

According to Nicholas Lardy, China achieved a stunning increase in trade through unilateral trade liberalization and reform even before its accession to the WTO.

Some participants were of the view that capital account restrictions provide shelter that enables governments to maintain “bad habits.” Others defended a more cautious approach to liberalization, arguing that “it is better to be safe than sorry.” Unconvinced, Lord Desai recalled the words of the Pakistani economist Mahbub Ul Haq, who said the skepticism engendered by the Asian crisis was akin to “one person traveling on a bullock cart and the other in a swanky car. The car breaks down, and the person in the bullock cart asks, what is the use of having a car?”

Both India and China embarked on a gradual process of capital account liberalization during the 1990s. Jonathan Anderson (UBS) observed that these two countries now had about the same degree of capital account restrictiveness—with India’s system somewhat more liberalized on paper, but with China experiencing higher volumes of flows. Another important finding was that full capital account liberalization was not a precondition for moving to a flexible exchange rate—India has operated a managed exchange rate regime in the presence of controls on inflows and outflows. A move to flexible exchange rates is desirable because nearly every emerging market financial crisis involved a “one-way” bet. The overall conclusion on capital account liberalization was “go forward—but at a rational pace.”

Financial institutions and growth

Is government ownership of financial institutions necessarily inimical to efficient financial intermediation? Is there a role for development finance institutions? Are gradual reforms the only way to go in the financial sector?

There was broad agreement with the view expressed by Governor Chen Yuan (China Development Bank) that sustained, high-quality growth requires “a sound and efficient financial system that accommodates the coordinated development of three forms of finance—budgetary, bank, and securities.” Participants noted similarities between India’s and China’s experiences in the financial sector—particularly in terms of the concentration of bank ownership, the role of specialized banks and credit institutions, and the high level of nonperforming assets. In both countries, government decisions affecting banks have been driven by a social contract to ensure a stable financial system. At the same time, there was broad agreement that neither China nor India is getting the contribution to growth it needs from its financial sector; the efficiency and quality of financial intermediation urgently needs to be improved in both countries.

Although participants agreed that public sector involvement in the financial system tended to blunt banks’ commercial incentives and give rise to regulatory forbearance, opinions were divided on whether a change in ownership was material to increasing the efficiency of the financial system. Proponents of privatization argued that as long as financial institutions remained in public hands, it was inevitable that they would be governed by considerations other than those that are primarily commercial or competitive. Those opposed to privatization noted there is little empirical evidence to support the view that private banks always perform better than public banks.

Participants agreed that development finance institutions can play a role in correcting market failures, but their history in both China and India suggests that they should adopt the highest standards of corporate governance within a commercially oriented credit culture. In this context, Governor Chen outlined his vision for the China Development Bank, a development finance institution. He pointed to the importance of high standards of transparency and financial controls, including external audits by international accounting firms, as well as strong discipline over the borrowers—the state-owned enterprises. Finally, participants generally agreed that it was sensible to undertake reforms at a measured pace in line with increased economic openness, available budget resources, and institutional constraints.

Photo credits: Denio Zara, Michael Spilotro, Eugene Salazar for the IMF, pages 361-68 and 373; Kuku Photographers, pages 361 and 372; Salim Amin for Camerapix, page 369; Jagdeesh N.V. for Reuters, page 370; LIU Jin for AFP, page 371; Luis Acosta for AFP, page 374; and Leila Gorchev for AFP, page 375.

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