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“The Development of the People’s Republic of China and India: Prospects and Challenges”

Clare Distinguished Lecture by
Haruhiko Kuroda
President
Asian Development Bank

At the Clare College Cambridge

1 February 2007
United Kingdom

I. Introduction

Ladies and gentlemen, thank you for this opportunity to share some thoughts about the People’s Republic of China (China) and India – their development paradigms, their prospects for the future, and their challenges.

As you know, the entire Asian continent is in the midst of an unprecedented transformation – from a largely agrarian and poor region in the mid-20th century, to a hotbed of dynamic growth and social progress today. Much can be attributed to the rapid reconstruction of post-war Japan, whose dramatic rise benefited the world in general and the Asia and Pacific region in particular. Japan became a significant source of foreign investment in the latter half of the 20th century, contributing in turn to the unleashing of the “Asian Tiger” economies – Hong Kong; Taipei,China; Korea; and Singapore – and the newly emerging economies of Southeast Asia – Indonesia, Malaysia, Philippines, Thailand and, more recently, Viet Nam.

But it is the awakening of the “Sleeping Giant” – China and later India – that is really forcing the world to take this transformation seriously. Over the past 25 years or so, China has averaged real GDP growth of close to 10% a year, and external trade growth of 16% – an astonishing feat, to say the least. In the same period, India has grown at just under 6% a year. But such averages clearly mask many changes over time. And it is important to note that India’s trend growth has accelerated steadily from about 4% in the 1960s to the early 1980’s, to around 7% to 8% in recent years.

The relative weights of China and India in the global economy have also increased substantially. For example, in 1980 China represented 1% of world GDP and India 0.9%. In 2005, those figures became 5.2% and 1.8% respectively. In the same period, China's share of global trade rose from 0.9% to 6.8% and India’s from 0.6% to 1.1%. Between 1980 and 2006, China’s foreign reserves grew from (USD) $2.5 billion to $1,066 billion, and India's from $6.9 billion to $177 billion.

Thus, with China as its lead horse, Asia as a whole is galloping ahead, soon to reclaim the place it held in the world economy some 200 years ago. Its share of world GDP is now approaching 30% – nearly double what it was in 1980. Importantly, Asian economies have leveraged that growth to reduce poverty and improve people’s standard of living. Between 1990 and 2003, the number of people living on less than a dollar a day declined by about 300 million. That still leaves more than 620 million living on such meager incomes, but the progress achieved to date is laudable.

Asia’s rapid economic advance over a relatively short span of time has led to much speculation about the future of China and India, and the future of global economic relationships. A well-known Goldman Sachs analysis predicted, for example, that China’s economic output will exceed Japan’s in the mid-2010s and that of the US in the early 2040s, and that India will surpass Japan in the early 2030s. Whether or not this particular scenario comes to pass, there is little doubt that the two together are creating a massive shift in global income and wealth distribution.

Since the 1997-98 Asian financial crisis, there has also been much speculation about whether Asia as a whole could experience a similar meltdown in the future. Of course, this possibility cannot be penciled out. But it is important to recognize that most Asian economies learned a great deal from the crisis and have taken major steps to strengthen national economic foundations, as well as the regional financial architecture. The domestic policy and institutional reforms they have undertaken and the region’s general economic resilience suggests that longterm growth prospects remain positive, provided that reforms continue and the global economy remains stable.

So, what of the future? What can China and India do to sustain rapid growth and manage their growing importance in the world economy? Will their future paths be complementary or competitive? Will their growth paths converge? How will smaller Asian economies avoid being overshadowed by these emerging giants? And how should the world respond to support and benefit from the emergence of China and India as economic heavyweights?

I will touch on some of these issues a little later in my talk. But first, to lay a foundation for such discussions, let’s take a look at the inside stories of China and India, and how their respective economic development paths have led them to where they are today.

II. China and India: Two Development Paradigms and their Prospects

It might be said that China and India in the 1970s were both essentially closed economies. Trade, for example, was tightly controlled in both countries – in China through the Foreign Trade Corporations and a web of restrictive measures, and in India through a very strict licensing system, which limited the size and quality of imports.

Beginning in the late 1970s, however, China began taking aggressive steps to open up to foreign trade, and to move from a centrally planned and largely agricultural economy to a decentralized industrial economy, with decision-making power increasingly delegated to provincial and local governments and to line ministries. In the 1980s, for example, China conferred direct trading rights on foreign invested and joint venture enterprises, created Special Economic Zones and Open Cities, and depreciated its domestic currency to encourage export of Chinese products.

In the 1990s, China continued to liberalize its economy and significantly reduced industrial tariffs to meet the entry requirements for the World Trade Organization. China also relaxed significantly its restrictions on inward foreign investment to invite foreign enterprises to operate in the country. The government today remains strongly committed to promoting private sector development, reforming state-owned enterprises and attracting foreign direct investment.

To support this direction, it has promulgated numerous new rules and regulations and established new regulatory agencies.

As a result, China has seen massive inflows of foreign direct investment – a total of $630 billion between 1986 and 2005 – and the foreign firms have increased export of manufactured products. China has thus become a formidable manufacturing competitor in export markets and a magnet for FDI.

The impressive progress of China’s economy can also be attributed, at least in part, to its well developed infrastructure. Since 1978, the Chinese Government has made enormous efforts to remove bottlenecks in transport, energy, and other rural and urban infrastructure. With large amounts of public and commercial funds poured into those areas, China has made unparalleled progress in building world class infrastructure. For example, twenty years ago, China had no single expressway. Today, at a total length of 41,000 kilometers, China’s expressway is the second largest in the world. Twenty years ago, China had just 60 wastewater treatment plants. Today it has more than 800.

India

While India, too, took initial steps to liberalize its economy in the 1980s, it was not until the ensuing decade that its reform agenda really began to take hold.

For most of its post-independence history, India’s economy was characterized by inwardlooking and import-substituting policies, an inefficient public sector, overregulation of private enterprises, stringent price and production controls and strict control over foreign trade and investment.

Perhaps prompted by China’s success, as well as its own financial crisis in 1991, India in the 1990s began reversing some of its harmful economic policies. For instance, it put an end to import licensing in capital and intermediate goods in 1991 and in consumer goods in 2001. It lowered tariffs and other trade barriers, reduced tax rates, loosened currency controls and opened the economy to foreign investment. India has raised its restrictive FDI limits in several subsectors, including banking, telecommunications and civil aviation, and continues to rationalize and modernize the direct and indirect tax administration. While not on the scale of China, India too has begun attracting inflows of foreign investment, totaling $53 billion between 1986 and 2005.

One of the major contributing factors toward India’s global emergence was the government’s decision to permit private sector participation as well as foreign investment in the services sector at a time when both domestic and global demand for services – particularly communications, banking and business services – were rapidly increasing.¹ This, along with the strong presence of India’s elite Institutes of Technology, has launched India to the forefront of IT and IT-enabled services, biotechnology, pharmaceuticals, and high-tech manufacturing. Overall, India’s service sector has grown rapidly, from less than 37% of GDP in 1980 to nearly 54% in 2005.

Whereas China has recently begun to encourage its domestic private sector to grow, India has already given birth to a number of large domestic firms, such as Infosys Technologies, Jet Airways and Wipro Technologies, that have proven to be fierce competitors in the international arena. This vibrant entrepreneurial growth platform is now attracting back many highly-skilled Indians from California’s Silicon Valley and elsewhere, increasing the country’s already admirable intellectual capital base.

Will China and India Converge?

Of all the world’s economies, only China and India have experienced such a rapid and sustained pace of growth. According to ADB’s recent estimates, China should be able to sustain a medium-term annual growth rate of about 9%, and India about 8% to 8.5%, if the global economic environment remains favorable. These rates are high even relative to other Asian economies’ performance. Risks to these forecasts might include a slowdown in the global economy, sudden hikes in global inflation due to higher oil prices and other factors, a rapid unwinding of global payments imbalances and mismanagement of domestic macroeconomic conditions and policies (e.g. overheating and overinvestment).

This leads to speculation on whether these two giant economies will converge in terms of paradigms and actual economic performance. In my view, much will depend on the pace of continued reforms in each country. India’s overarching challenge is to accelerate growth through structural reforms, productivity improvements, job creation and infrastructure development. It also needs to develop a more vibrant and diverse manufacturing base, attract more foreign direct investment, and expand exports. China, on the other hand, needs to move to a more sustainable growth level by rebalancing the economy toward greater domestic consumption, improving the quality of investment, and increasing the share of services in the economy.

Clearly, sustained, inclusive growth in these two giant economies would have profound benefits not only for the people of China and India, but also for the Asia and Pacific region and the global economy overall. But from each of these perspectives, there are equally profound challenges to overcome. So let me turn to some of those challenges, beginning with China and India specifically, and then moving out to the wider international community.

III. Challenges Ahead

China’s Challenges

It may be argued that even without further major policy reforms, China could and most likely would sustain its current growth rate for the next decade, and possibly longer. However, there are many issues that could slow or derail its progress.

First, China still lacks some of the key institutional foundations of a market economy. In particular, China needs to continue to move towards a well functioning, efficient and marketbased financial sector. While some progress has been made, China’s state-owned banks remain inefficient, with potentials for high levels of non-performing loans. China’s accession to the WTO requires that it open its banking market to foreign participation. This poses clear challenges for these inefficient state banks, which must do more to improve corporate governance, management efficiency and asset quality. This will also require continued reform of China’s state-owned enterprises, or SOEs, which largely determine banks’ asset quality. A further requirement is regulatory reform for a market economy and the development of a legal system with a competent, independent and powerful judiciary. The latter may take at least a generation to develop.

Second, China continues to experience significant environmental problems, especially since its economic boom is being driven largely by industrial development. A report released in 1998 by the World Health Organization (WHO) noted that of the ten most polluted cities in the world, seven can be found in China. China's energy consumption accounts for approximately 53% of emerging East Asia's (i.e., excluding Japan) total energy consumption and it is the second largest emitter of energy-related carbon dioxide emissions after the United States. In 2005, China consumed 1.2 tons of coal for every CNY10,000 of GDP – about three times that of the US and 10 times that of Japan². Clearly, it will be necessary to find solutions to this major problem, which affects not only China but Asia and the entire world.

Third, while economic and social development performance in China has been impressive and poverty has come down, large segments of the population continue to be disadvantaged in terms of access to economic opportunities and quality social services. Most recent estimates suggest that as of 2003, 13% of China’s population still lived on a dollar a day or less. Rural-urban disparities are of particular concern. The rural poor are somewhat concentrated in the more remote upland and mountain areas which have witnessed limited gains in agricultural productivity, impact of economic reforms and infrastructure investments. And over the past 15 years, substantial disparities in regional living standards have emerged. Per capita GDP in the western region is about two thirds of the national average and only one third of that in the eastern coastal region.

To address these disparities, and to sustain its rapid pace of growth, China needs to continue investing in infrastructure, education and health. There is a wide gap in the development of physical infrastructure including roads and railways between western China and the rest of the country. And there are policy weaknesses in the infrastructure sector, including weak financing, high accident rates, and poor corporate governance of the state-owned infrastructure providers.

Compared to other developing economies, China has shown impressive progress toward eliminating illiteracy, universalizing a compulsory 9-year education and achieving a 73% secondary school enrollment ratio. However, there are great disparities in education access, quality, and outcomes across urban-rural, regional, and gender dimensions.

Furthermore, overemphasis on the "user pay" principle in both compulsory education and public health threatens social service access for poor households. For example, since beginning its economic reforms, China has moved away from an exemplary public health system and toward an increasingly commercialized one.³ The result has been increasing disparities in both health insurance coverage and health outcomes between rural and urban populations, and between poor and rich households. If these health inequalities are not addressed, a large segment of China’s population will be worse off than what they had been prior to the initiation of economic reforms.

India’s Challenges

Turning to India, we see that prospects for sustaining and accelerating growth will depend on implementing difficult reforms in several key areas.

India remains an extremely poor country, with 31% of its population earning less than a dollar a day. Most poverty-related education and health indicators for India continue to show disturbing gender gaps, large rural-urban differences, and wide variation across states. In Kerala, for instance, one out of every hundred children dies in infancy. In Orissa, the figure is nearly nine times that high. The contrast in infant mortality rates between rural and urban areas, and between the lowest asset quintiles and highest, are striking. Mothers who have no education are another high risk group, with an infant mortality rate nearing 9%, compared to about 4% for those with a secondary education or better.⁴ The potential economic and social costs associated with these and other inequities are enormous. India needs to make major investments in education and health to begin to overcome these damaging disparities.

India is trying to tackle its inequality challenge through the $39 billion program of Bharat Nirman to enhance the quality and reach of rural infrastructure, which will help create productive farm and non-farm employment opportunities. The National Horticulture Mission, which is upgrading irrigation infrastructure, expanding the rural roads network, and strengthening agricultural storage and marketing infrastructure, will help increase value added agriculture industries. And the recently launched National Rural Health Mission will also improve access of the rural poor to basic health services, resulting in fewer productive days lost to illness.

India must restructure its economy to create jobs for its hundreds of millions of unemployed and underemployed people. While the booming services sector provides opportunities for the few, 90% of India’s people are trapped in low-productivity, low-wage jobs in the informal sector⁵. Nearly two thirds are employed in agriculture, a sector that produces less than one fifth of GDP. India’s agriculture sector is characterized by a lack of diversity, low wages and an oversupply of labor. With depressed employment and wages, incentives for mechanization are limited, and productivity growth is constrained. Since the lack of irrigation is a major problem, India will have to manage its water resources much more effectively to further develop the rural sector. It should also invest in research and development to support diversification into agri-processing industries. And, it needs to develop suitable market institutions and stronger links between farmers and the consumers of farm products.

India’s manufacturing sector, which represents just over 16% of GDP, also needs to grow rapidly to boost the overall growth rate, and to generate jobs. In several industrial activities, firms are beginning to integrate into global supply chains and have achieved rapid export growth. Pharmaceutical companies, for example, have adopted a strategy of R&D-based innovative growth, which could allow the industry to move beyond its current mainstay of generic drug manufacture. Overall, however, the manufacturing sector has not grown – and in fact has shrunk by a small margin as a percentage of GDP – since 1980.

Despite recent reforms, real barriers to industrial development remain. For example, India’s long-standing policy on designated small scale industries bars large firms from producing a large number of goods. Although the Government has, over the last five years, taken steps to reduce the number of protected industries, much more needs to be done. At the same time, while trade has opened up significantly, foreign ownership of firms remains limited to 40% in most cases. It is worth noting that, between 1986 and 2005, India attracted less than one-tenth the FDI to China in the same period. While some important steps have been taken, a number of sectors, including agriculture and retail trade, remain off-limits to foreign investment.

Another issue is labor market regulations, which have seriously impeded employment growth in the formal sector and induced firms to funnel resources toward capital-intensive rather than labor-intensive sectors. However, it is not clear that across-the-board reforms of these regulations will induce significant employment creation. As a recent Asian Development Bank study shows, labor laws in practice apply to only 7% of the labor force, those working in the formal sector. Thus, while rationalizing a few of the most damaging laws would indeed be helpful, there may be other more significant barriers to investment.

Certainly one of the barriers is India’s lack of modern, reliable infrastructure. India’s economy desperately needs more and better roads, ports, railways and power supplies. Per capita energy use is only half that of China’s and its per capita power consumption only a third. Despite its advances in technology, India’s telecommunications infrastructure is dismal. Less than 10% of people are fixed line or mobile phone subscribers. Barely 3% are Internet users. This poor economic infrastructure is a major impediment to investment and hampers the country’s productivity.

The Government’s ambitious programs for national highways, rural roads, railway freight corridors, power generation and transmission, and urban infrastructure are positive steps towards solving its infrastructure crisis. The $27 billion National Urban Renewal Mission, for example, will reduce pressure on India’s mega-cities, and create adequate infrastructure in other cities across the country. It is estimated that, by 2021, 40% of India’s population will live in urban centers. Under the urban renewal mission, 63 cities will benefit from better housing, water and sanitation – and ultimately, better delivery of other basic services such as health, education, and social security.

Finally, like China, India is grappling with significant environmental problems. Its rapidly growing population has placed significant pressure on both its infrastructure and its natural resources. Deforestation, soil erosion, water pollution and land degradation continue to worsen and are hindering economic development in rural India, while rapid industrialization and urbanization are straining the limits of municipal services and causing serious air pollution problems.

India is responding to these problems with in a number of ways, such as introducing environmental standards for industry, reducing subsidies on low-quality coal, and supporting air quality and alternative fuel initiatives.⁶ But as the country continues to become more urbanized and its need for energy continues to soar, strong enforcement efforts will be essential.

IV. China, India, Asia and the World

Clearly, both China and India have many challenges ahead. But given their progress to date, there is reason to be optimistic that they will take on these challenges. That their impact on the global economy will continue to grow will present huge and fast growing markets and export opportunities for producers across Asia, and around the world.

The rise of China and India is certainly putting pressures on other Asian economies. But, as witnessed at the 2nd East Asia Summit held in mid-January this year in Cebu, Philippines, the momentum towards deeper Asian integration is growing. Increased regional cooperation and integration within Asia as a whole is necessary to spread the benefits of growth and facilitate integration of all with the global economy.

Smaller economies within the region can benefit from deeper integration through better access to the neighboring economies and the global economy. To do so, they too face the challenge of ongoing economic, institutional and governance reforms at the national level. As the smaller and less developed economies take the necessary steps to catch up, the larger economies will also benefit from finding new markets and building new links in the regional supply and production chains.

Given their size and economic weight in Asia, as well as their strategic locations, China and India are well positioned to increase their engagement with other regional economies, even as they seek further integration with the global economy. Both are increasingly working within multilateral frameworks. Both are investing in their neighbor economies – China more so than India. China and India are crucially important to the growth of Central Asia and are participating in Central Asian regional initiatives. And the growth of both economies is inducing Asia’s most developed regional body – the Association of Southeast Asian Nations, or ASEAN—to promote further integration among its members and with its neighbors.

In this respect, India’s presence at the recent East Asia Summit was an important signal of its desire to form closer ties with East Asian economies. It is to be hoped that India will take similar opportunities to forge stronger relationships within South Asia as well. Doing so would not only benefit India and other South Asian economies, but would also help bring East Asia and South Asia together toward a broader, pan-Asian economic integration.

It is also desirable for China and India to substantially increase their own bilateral ties through increased cooperation. Recent trends show that some progress has been made. For example, in 1990, the volume of trade between China and India was only about $260 million. In recent years, it has risen by 20% to 30% annually, and is expected to reach $20 billion this year, and double that amount three years from now. But even this level of bilateral trade is only a small fraction of its potential, representing about 8% of India’s total trade and less than 1.5% of China’s total trade.

Improving trade between the two countries could be a long and complex process, given their tariffs and non-tariff barriers, unique customs rules and procedures, incomplete connecting physical infrastructure, insufficient bilateral investment activities, and limited movements of people. There are also long-standing political disputes which have engendered a lingering distrust. Nevertheless, leaders of both countries have taken important steps to move forward within the context of greater cooperation. For example, they re-opened cross-border trade at the Himalayan Nathu Pass in July 2006 – 44 years after it was closed due to a border war between them.

In another positive step, a joint study group was created following the Indian Prime Minister’s visit to Beijing in 2003. The group recommended a series of measures to promote and facilitate trade in goods, services, investment and other areas, and suggested the formation of a Joint Task Force to study the feasibility and benefits of an India-China regional trading arrangement, and the first meeting of the Task Force was held in March 2006.

More recently, in November 2006, China’s Ministry of Commerce announced that it is considering talks on a free trade agreement with India. Also in November, during the visit of China’s President to India, the two sides signed as many as 13 agreements to, among other things, provide a framework for bilateral investment flows and to ensure that Indian and Chinese investors receive fair treatment and legal protection in each other’s countries. While there are numerous areas in which the two economies are natural competitors, there is also great potential for them to exploit their complementarities to achieve mutual gains.

For example, labor intensive services are a potential source of growth for both China and India, and realizing this potential will depend on growth of services trade. Interestingly, India’s success in services and China’s success in manufacturing have generated interest at the highest policy making levels in a collaborative effort to capture a sizable market share of the global market for both.

At the international level, many industrial nations view China’s and India’s increasing shares in global markets as a threat. But competition is inherent in any attempt to pursue gains from trade and international division of labor. Shocks to China’s import demand or export supply can be sources of risk to other countries, but could also be a source of insurance.

Countries around the world must recognize the importance of containing and forestalling the rise of protectionism. And Asian countries, particularly China and India, must foster policies that provide incentives and climates that support innovation, risk-taking and efficient resource allocation.

Increased competition across the global economy can have benefits for all if managed effectively. We saw in the 1980s and ‘90s, for example, how increased export competition from East Asia helped induce the acceleration of European economic integration. It is to be hoped that Asia’s rise this time can stimulate Europe to increase its productivity and competitiveness, and to embrace Asia as a full partner in the global economy.

V. Concluding Remarks

Ladies and gentlemen, during my talk today I have given you a brief sketch of China’s and India’s development paradigms, and the challenges they face going forward. And I have offered some thoughts on what China, India, and other countries in Asia and elsewhere, can do to promote continued growth and poverty reduction in these two very populous, important countries in the context of the global economy. And I have suggested ways that China and India can strengthen their own ties to each other to promote deeper integration of economies in the region, and of the region with the world.

Many questions remain, but one thing is certain. The rise of China and India has already changed the global economic landscape in dramatic ways. Both have a long way to go to reach their full economic potential, and neither will achieve their goals without the participation of the international community. It is my sincere hope that the world will embrace and support their progress, recognizing their immense potential to contribute to a new era of global growth, poverty reduction, stability and peace.