Asia Pacific: China and India: New Tigers of Asia
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Andy Xie and Chetan Ahya
Morgan Stanley
Jul 26, 2004
The rise of China and India is the most important economic force in the world. Together, they account for 40% of the global population of working age and 18% of the global economy, on the basis of purchasing power parity (PPP). For two decades, their economies have been growing twice as fast as the rest of the world. On present trends, it will take just two decades before their share of the global economic pie will match their share of the global population. Indeed, in a decade, China's economy should surpass that of the US and India’s should be bigger than Japan's (using PPP).
This is mean reversion on a historical scale. Before industrialization, per-capita income was roughly the same among major economies (see A Century of Unrivalled Prosperity, Rudi Dornbusch, April 1999). Living standards in the West took off in the 19th century after the industrial revolution. India and China's agrarian economies could not compete in the global marketplace, and were able to stand on their own only in the 1950s. Then, economic planning that was supposed to be a short-cut to industrial progress turned out to be a cul-de-sac.
Later, economic liberalization at home and globalization abroad triggered two decades of sustained high growth for India and China. For the first time in two centuries, they are key players in the global economy. Moreover, they may determine global economic cycles in future, as they now account for the majority of global growth.
China adopted the East Asian model of export-led growth — and with a vengeance. Overseas Chinese provided the expertise in manufacturing outsourcing, and in turn enjoyed much cheaper labor and infrastructure than at home. As China's age dependency (proportion of non-working to working population) declined, much of the income from exports was recycled to build up the infrastructure necessary to keep the export sector competitive. Such a virtuous cycle delivered average annual rises of 8% in per-capita income over the past 25 years; the number of people living in town and cities doubled to 40% of the population in the same period.
India's relatively higher age dependency ratio was a hindrance to emulating China's success in manufacturing exports. Growth came from: (1) rationalizing its domestic economy (i.e., improving total productivity) and, more recently, (2) exporting IT and IT-enabled services. In the past 25 years, India's per-capita income has expanded by 3.2% per annum and urbanization has lifted to 28%. Growth in per-capita income has been back-end loaded, at 4.3% in the past 10 years from 2.4% in the previous 15 years.
China's most successful policy initiatives have been in modernizing its infrastructure, allowing labor mobility, welcoming foreign direct investment (FDI) and embracing competition. About 150 million workers have migrated from the farms to the dynamic local economies of coastal China. Money that these factory workers remitted home has helped develop the interior provinces. Competition in local markets has kept down prices, and as such has allowed wages to stay low and globally competitive.
India has an established commercial class. Economic liberalization has been of the more traditional variety, with the private sector mainly driving the turnaround of the past decade or so. Conspicuously successful have been the local entrepreneurs who created world-class companies after seizing the opportunity offered by the outsourcing of IT services.
China has relied on administrative power and flexibility, rather than market forces, to guide capital formation. Capital allocation is inefficient and prone to corruption, as a result of which non-performing loans have piled up in the banking system. China's government recognizes that radical reform is necessary to avert a financial crisis. State banks are to be listed. NPLs are being sold. Global banks are being allowed strategic stakes in Chinese banks to bring in best-practice standards and practices. Even so, China is many years away from an independent and market-driven financial system.
India's challenge is to boost its savings rate to upgrade the country's infrastructure, which would cut the cost of doing business and boost growth. Net capital formation is a mere 15% of GDP. If the fiscal deficit could be reduced — from the current 10% of GDP — and resources freed up for investment, India could boost its growth rate by 1-2 percentage points, on our estimates. Increased income from exports of IT services - which we believe, on a conservative basis, could more than quadruple by 2010 - could play a key, if indirect, role in alleviating the infrastructure bottlenecks that are holding back India from being a major competitor to China in the export of manufactured goods.
China, by contrast, has yet to benefit from service exports, the new phase of globalization. With 3 million college students graduating every year, China has the skills base to become a major player in global services, once it identifies the segments in which it might have a competitive advantage.
Over the next 10-15 years, we see the development models of India and China converging. Both low-cost countries will be driving forces in the trade of goods and services, with their exports possibly rising from a combined 12% of the global total today to 20% by 2010 and 30% by 2030. (Our calculation internalizes euro-zone intra-regional trade.)
Such an outcome could result in a restructuring of the global economy, in several ways. Neither India nor China is self-sufficient in exhaustible natural resources — with a few exceptions in the case of India — and rising demand for such relatively scarce commodities will make them more expensive. With both countries having vast pools of low-cost workers, that will inevitably depress prices for manufactured goods and tradable services. While that might lower wages in some industries in other countries, consumers across the globe would have greater purchasing power.
Global companies are best poised to benefit from India and China's greater annexation of overseas product and service markets. Indeed, most of the growth for such companies could come from the industrialization and globalization of India and China.
Globalization has underpinned the economic progress of China and India in the past 25 years. If the next quarter of a century were to unfold similarly, China and India would be mostly industrialized and in turn would be both economic exemplars and major markets for poorer countries.
Such a best-case scenario is by no means guaranteed, of course. Globalization could be held back by internal constraints in the US or Europe or by external forces. A slackening in the pace of globalization would rein back industrialization in India and China. Such vicissitudes, though, would delay rather derail their economic progress — and would be no big deal in a historical sense. In short, India and China look to be on track to emerge as developed economies within the next few decades.
China and India: China Far Ahead, But India Picking Up Speed
China and India have emphatically made their presence felt in the rapidly globalizing world economy. These two countries have been among the fastest-growing economies in the world. China and India together now account for 18% of world GDP on a PPP basis, compared with 10% in 1990. More importantly, these economies have emerged as the global growth engines. On a PPP basis, these two economies accounted for 32% of global GDP growth in 2003, compared with 13% in 1990. Nominal dollar GDP for China and India has grown at an average of 8.3% and 7.0%, respectively, over the last five years, compared with 4% for the World Ex China and India.
Positive Demographics and Structural Reforms
Both countries have adopted major internal and external structural reforms to accelerate growth. These reforms have positioned them firmly on the rising path of S-curve for income growth. Both are using the opportunity presented by their rising working-age populations (declining age dependency). Declining dependency typically helps initiate the virtuous cycle of higher growth--savings-investment-growth. India and China already have a 17% and 23% share, respectively, of the global working-age population and should maintain their share over the next five years. Indeed, by 2010, India and China should add a further 83 million and 56 million people, respectively, to the global labor pool. In comparison, the US and Europe should add only 13 million and 0.1 million people, respectively. The world's third-largest economy, Japan, will see a decline of 3 million in its working population over this period. While China has already successfully appended a significant proportion of its working-age population to the global labor supply chain, India is just beginning to follow suit.
Many Similarities, but China Has Left India Far Behind
The similarities between the two countries are many, including populations of more than a billion, and traditionally poor agrarian economies. In 1982, China's per capita nominal dollar GDP, at US$275, was marginally lower than India's, at US$280. However, over the last 21 years, China's growth has been far stronger than India's. During this period, China's real GDP increased by an average of 9.7% pa compared with India's 5.7% pa. In 2003, as a result of this strong growth, China's GDP of US$1.4 trillion was 2.5 times India's GDP of US$575 billion, and its per capita income, at US$1,086, was twice that of India. Moreover, in terms of share of world nominal dollar GDP, China's 3.9% is much higher than India's 1.6%. In terms of PPP-based GDP, China’s share is 12.6% compared with India's 5.7%.
China's Share in Global Exports Is Nearly 6x India’s
China has been able to accelerate the process of integration into the global economy at a much faster pace than India. China's share in global goods and services trade is 5.2%, compared with just 0.9% for India. We believe that the inflexion points for both the countries have been their decisions to embrace structural reforms and open their economies. However, China's exports have grown at a much faster pace than India’s in the first few years post the implementation of reforms. China's exports of goods and services in the first 12 years post reforms expanded at a CAGR of 16.3%, while India's exports of goods have increased at a CAGR of 9.9% since 1991. The sharp differential in export and GDP growth rates can be explained by the differences in two growth models and the pace of reforms.
China's Fast-Track Growth Model
In the 25 years since China initiated reforms, it has grown at an average of 9.4% pa, compared with average growth of 5.8% pa in the 25 years prior to reforms. This sharp acceleration in economic growth has been achieved by implementing major structural reforms. The government has focused on improving its human capital with a universal mandatory nine-year education requirement and by implementing aggressive labor reforms. Higher domestic savings, aided by positive demographic changes and rising FDI due to low foreign investment barriers, have helped increase capital accumulation. The accumulated capital has been rightly channelled into development of an infrastructure network to build scale of operation, which in turn enables the effective use of cheap labor. A focus on exports supplements domestic demand and improves cost competitiveness. The single-minded determination of the politicians to 'make it happen' differentiates China from other emerging countries. We expect China to maintain its 8%-plus growth trend over the next 10 years as long as it manages to reform its financial sector and establish a market-oriented institutional framework.
India's Unique Gradualism Growth Model
India has followed a gradual consensual approach to reforms. In that sense, India has been a unique emerging market model, which has put greater emphasis on evolving a well developed institutional framework. This includes the rule of law, protection of property, various market regulators, a democratic political set-up and redistribution agencies. Since the early 1990s, India has initiated internal and external reforms, including deregulation of business investments, deregulation of factor input and output prices, significant reductions in tax rates and relaxation of restrictions on foreign capital investment. However, India's average GDP growth of 5.8% in the post reform period (1992-2003) is the same as that in the 1980s. While economic reforms implemented in the past 12 years have not meaningfully helped to accelerate GDP growth, the big differences have been improved macro stability and reduced volatility in output. However, we believe that, in many ways, the growth trend in India does not reflect its full potential, resulting in rising stock of unemployed. We see a good chance that India will achieve its potential growth of 7% plus over the next 10 years if it addresses its large government revenue deficit (tax and non-tax revenues less revenue expenditure) and its need for infrastructure development.
India Is Trailing China by 10-13 Years
India's per capita GDP will reach the current level in China in 13 years if India's real GDP grows at its current trend of 6%, or in 10 years if India's real GDP grows at 8%, on our estimates. India’s overall GDP will take nine or seven years, respectively, to reach the current level in China if it grows at 6% or 8%, respectively. By 2015, if India and China maintain their average growth trends of the last 10 years, the nominal dollar GDP of the two economies will reach US$1.3 trillion and US$3.9 trillion, respectively. If India manages to grow at a higher rate of 8%, its GDP will reach US$1.6 trillion by 2015.
Competitiveness: Who's the Winner?
We believe the recent trends in exports are a good measure of current competitiveness for the two countries. China's overwhelming presence in global trade is demonstrated in its superior overall share of global exports. On a sectoral basis, India's top exports are biased in favour of sectors with high labor intensity and low capital intensity. India's top five export segments are: Commercial Services, Gems & Jewellery, Engineering Goods, Agricultural Goods and Textiles. In comparison, China has been able to succeed in almost all manufacturing segments. China's success is higher in segments with high labor and capital/infrastructure intensity. China's top five export segments are: Electronics, Computers & Telecommunications, Machinery, Garments and Services. Indeed, in terms of global export share, India leads China only in the steel and software sectors.
Going forward we believe both India and China will continue to do well in labor- and skill-intensive sectors. However, we think India needs to implement aggressive reforms to match China's pace in labor and skill intensive manufacturing sectors. In resource-based industries, India could build an edge over China. Again, in this area, building scale would test India's capability to establish and maintain a network of critical physical infrastructure. In infrastructure- and capital-intensive sectors, we expect China to maintain its lead over India. We believe there is a good chance that India will start fighting for its space even in these sectors in 5 to 10 years as its savings improve, allowing the country to build critical physical infrastructure facilities.
Many Challenges Ahead for the Two Economies
The structural story of these two high-growth economies is unlikely to reverse soon, in our opinion. There are no parallels to China's manufacturing success and the growing importance of India's services outsourcing platform. However, the near-term challenges facing these countries cannot be ignored. China's key challenge is to implement critical reforms to improve its institutional framework, especially the financial system, while India is facing the risk of delays to much-needed 'big shift' reforms.
We believe India has to accelerate its economic reform process and create more productive job opportunities to ensure social stability. In our view, to accelerate its sustainable growth trend to 8%+, India needs to initiate the following seven-point program, among other reforms: (1) focus on developing its human capital, especially increasing the availability of primary education to its young population; (2) augment its savings rate through fiscal reforms; (3) increase capital accumulation through FDI and privatization; (4) kick start investment in infrastructure; (5) reform the tax structure; (6) improve labor flexibility; and (7) initiate effective decentralization of government authority and responsibility.
China is facing its own set of challenges. In our view, the area in greatest need of reform is the financial sector. China's weak financial sector is already hurting its economy. The recent overheating of the economy, with fixed investments growing at 45% in C1Q04, is a case in point. Indeed, we estimate that the overshooting in the current economic cycle has resulted in excess investment of almost US$200 billion. The Chinese government has had to supplement monetary measures with administrative measures. We believe it needs to implement major financial sector reforms and empower the Central Bank to act preemptively against any overshooting of the economic cycle. For China to sustain its 8-9% pa growth, we believe, the government needs to initiate the following four-point program, among other reforms: (1) install a more market-oriented institutional framework; (2) implement major financial sector reforms; (3) encourage greater participation from private-sector entrepreneurs; and (4) increase its focus on tertiary education to meet the growing needs of the competitive economy.
Conclusion
In today's rapidly globalizing world, the huge surplus working populations in India and China are making it imperative for the rest of the world to recognise these countries' key role in global competitive dynamics. India and China are creating new rules for global manufacturing and services output dynamics. Indeed, both countries are increasingly becoming an integral part of business strategy plans for global companies, and should be the structural drivers for global productivity and disinflation. Surplus labor in China has already had a major impact on global inflation, and India has an increasing role to play in influencing this trend.
China has already achieved a 5.9% share of the US$7.5 trillion global goods export market. India, with its more recent entry into the services export arena, has built a 1.6% share of the US$1.7 trillion global services export market. We estimate that India's share has reached almost 2% (closer to 5% in the outsourcing market) of the US$450 billion global IT services market. It is likely to follow a similar trend in the IT-enabled business process outsourcing market of US$775 billion, where it currently has a share of only 0.5%. We believe that, in the next few decades, India and China will remain the two most dominant secular growth stories globally.
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